How to Make Decisions like Ray Dalio

What is most interesting to me about Ray Dalio is his decision-making process. This blog post is limited to a discussion of that process and not Bridgewater’s philosophy generally. If you are interested in understanding Bridgewater and Dalio more broadly, Dalio has a book coming out this fall which expands on his widely circulated “Principles” document.  I have written a more general blog post about Dalio on this blog, which you can find a link to in the Notes to this post.

Anyone who has read and understood the books and essays of Michael Mauboussin knows that people who have a sound decision-making process have better outcomes in life (not just in investing). Dalio’s view tracks Mauboussin’s view: “I think that every single day there are many decisions that people make and they all have consequences. And your life essentially depends on the cumulative quality of the decisions you make.” Having said that about the importance of making wise decisions in all aspects of life, thinking about how Dalio makes investment decisions is a particularly effective way of understanding his process. These quotations from Dalio set the table for a discussion of his decision-making process:

“You have to be an independent thinker in markets to be successful because the consensus is built into the price. You have to have a view that’s different from the consensus.” 

“To win at stocks or entrepreneurship, you must bet against the consensus and be right.”

Andy Rachleff makes the same point as Dalio is saying in this way: “Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”


Another adherent to this idea is Howard Marks who has said: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Being genuinely contrarian means the investor is going to be uncomfortable sometimes. Some people are good at being uncomfortable, and some are not.

Dalio believes:  

“Most other professions you can build on existing knowledge. You don’t have to have a point of view. If you’re a doctor and somebody breaks a leg or whatever, you can repair that leg. It’s not zero-sum, in the sense that you have to be smarter than the next person or different from the consensus. Now in order to be different from the consensus, there’s a high risk you’re going to be wrong.”

“Find people of alternative points of view and have quality conversations back and forth. Not to let them think for me, not for me to follow their point of view, but for me to understand the different perspectives. Because it increases my probability of being right, and it reduces my probability of being wrong.”

“When you have a view that’s different from the consensus, you’re gonna be wrong a certain number of times.  It teaches you humility.  The most important thing is to have humility and to think about ‘how do I get the best decision?’ It doesn’t have to come from me, I just want to be right.”

“Decision-making should be two steps. The first step is taking in information, particularly if there is disagreement, to understand that disagreement and then to make a decision. You have your right to make a decision. But it is so stupid not to take the time to take in and explore disagreement that might help prevent yourself from being wrong.”

The desire to explore disagreement is the foundation of Dalio’s drive to create “radical transparency”? Dalio describes this concept as follows:

“I want an idea meritocracy.  I want independent thinkers who are going to disagree.  The most important thing I want is meaningful work and meaningful relationships and the way to get that is through radical transparency.”

“Meaningful work is being on a mission that you’re excited about and that you can get your head into. And in meaningful relationships you can be totally transparent with each other, letting each other know what your weaknesses are.”

As context, what Dalio is setting out to do as an investor is extraordinarily hard. To say that a tiny number of people outperform the markets by making macro bets is a radical understatement. A handful of people have been able to do this successfully over many years at scale. Dalio has discovered a source of alpha (outperforming a benchmark) through a process that results in better decisions.

Here is my short “boil the ocean” description of his decision making process: Dalio starts with a rational analysis of the information he has and from that he forms a hypothesis. He then exposes that hypothesis to thoughtful people with alternative points of view and methods of analysis who may disagree with him and then he wants a radically transparent “back and forth” discussion. As part of that process he wants to deeply understand the reasoning of any thoughtful opposing views. Only after he has understood these alternative points of view does Dalio believe he is in a position to reject or accept the alternative ideas and make a decision. Dalio’s approach is quite similar to Charlie Munger’s approach: “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

Why would Dalio join Twitter this week? Well, if you do use Twittter properly you can get exposed to real time views of smart people who think differently and who may have opposing views. He seems to understand a key point about Twitter’s value when he tweeted this past week: “Look forward to learning from my mistakes in a whole new way.” Bob Lefsetz explains why Twitter is so unique:



Many people treat Twitter as a broadcast medium which is a shame since the value of interactive discussion is so much higher. Many people also turn their Twitter feed into a echo chamber, which is a lost opportunity. Jason Zweig has a great column this week where is describes why “Investors have a hard time looking the truth square in the face” and the creation of echo chambers of all kinds makes the problem worse.

Dalio and Munger share other approaches to decision-making. For example, Munger, who describes his process as follows: “I use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? The first track is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. Second, [I work to eliminate] influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often malfunctions.” Munger and Buffett also have a third step in their decision-making process that is similar to Dalio: expose their ideas to the best minds they can find. In Buffett’s case that mind is almost always Charlie Munger. Buffett calls Munger the “Abominable No Man.” Buffett exposing an investing hypothesis to Munger is like tempering steel    if an investing hypothesis doesn’t break after being exposed to Munger it is more likelky to be sound.

Having a diverse “posse” of experienced people that you trust look at a potential investment is wise if you want to avoid making too many mistakes. Philip Fisher, an investor who Munger and many other investors learned a lot from, maintained a “scuttlebutt” network of people who he would call for advice or expertise, Munger has said: “Even Einstein didn’t work in isolation. But he never went to large conferences. Any human being needs conversational colleagues.” Buffett once gave a huge compliment to Munger’s value as a person who can stress test his ideas when he said: “I try to look out 10 or 20 years when making an acquisition, but sometimes my eyesight has been poor. Charlie’s has been better; he voted ‘no’ more than ‘present’ on several of my errant purchases.”

To review what I have said in this post so far, the decision making process that Dalio, Buffett and Munger use is:

(1) make the most rational decisions you can;

(2) look for psychological bias that may have interfered with making a rational decision; and

(3) expose your hypothesis to very smart people who have a thoughtful contrary view and deeply understand their position.

On this last point Daniel Kahneman believes: “To better avoid errors, you should talk to people who disagree with you and you should talk to people who are not in the same emotional situation you are.”

Dalio believes that the more a person repeats this process over the years, the more they learn. What does this sound like to you? It is essentially what Munger calls “Worldly Wisdom.” Dalio sounds very much like Munger here:

“What I’ve discovered in that process is that I was learning so much. So just imagine what a fantastic path to think.” “Let me go after the person who has got the opposite point of view, who is really smart, and let me have quality conversations, quality disagreement.” “I get clear feedback. The goal is: don’t be too wrong. Be more right than wrong. So in that process I can take personal accountability. If I don’t learn personal accountability, if I don’t learn, then I’m going to pay a terrible price. So that process itself lent itself to this kind of very open-minded decision. Also the making mistakes, and the loving the mistakes.”

“There’s an art to this process of seeking out thoughtful disagreement. People who are successful at it realize that there is always some probability they might be wrong and that it’s worth the effort to consider what others are saying — not simply the others’ conclusions, but the reasoning behind them — to be assured that they aren’t making a mistake themselves. They approach disagreement with curiosity, not antagonism, and are what I call ‘open-minded and assertive at the same time.’ This means that they possess the ability to calmly take in what other people are thinking rather than block it out, and to clearly lay out the reasons why they haven’t reached the same conclusion. They are able to listen carefully and objectively to the reasoning behind differing opinions. When most people hear me describe this approach, they typically say, ‘No problem, I’m open-minded!’ But what they really mean is that they’re open to being wrong. True open-mindedness is an entirely different mind-set. It is a process of being intensely worried about being wrong and asking questions instead of defending a position. It demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.”

Dalio’s famous principles document provide a guide to decision making at Bridgewater. Many of these principles you have seen other investors say on this blog. For example:

“190) Recognize the Power of Knowing How to Deal with Not Knowing

191) Recognize that your goal is to come up with the best answer, that the probability of your having it is small, and that even if you have it, you can’t be confident that you do have it unless you have other believable people test you.

192) Understand that the ability to deal with not knowing is far more powerful than knowing a) Embrace the power of asking: ‘What don’t I know, and what should I do about it?’ b) Finding the path to success is at least as dependent on coming up with the right questions as coming up with answers.

193) Remember that your goal is to find the best answer, not to give the best one you have.

194) While everyone has the right to have questions and theories, only believable people have the right to have opinions

195) Constantly worry about what you are missing. a) Successful people ask for the criticism of others and consider its merit. b) Triangulate your view.

196) Make All Decisions Logically, as Expected Value Calculations

197) Considering both the probabilities and the payoffs of the consequences, make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil. (a) The cost of a bad decision is equal to or greater than the reward of a good decision, so knowing what you don’t know is at least as valuable as knowing. (b) Recognize opportunities where there isn’t much to lose and a lot to gain, even if the probability of the gain happening is low. (c) Understand how valuable it is to raise the probability that your decision will be right by accurately assessing the probability of your being right. (d) Don’t bet too much on anything. Make 15 or more good, uncorrelated bets.”

What typically gets in the way of the process like Dalio wants to create? Ego and organizational politics.

A. The ego of the decision maker is so often the source of a problem or mistake. Dalio says that it is emotionally hard to be radically transparent.  Warren Buffett writes: “It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it… we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.” What Buffett describes is an example of what Charlie Munger calls inversion. Instead of just trying to be smart, it is wise to focus on not being stupid. Dalio believes:

“People are so attached to being right, and yet the tragedy is it could be so easy to find out how you’re wrong. If you just said to yourself, “I’m not sure that I’m right, and let me go find people who have alternative point of views and let me have quality conversations.” Not to pay attention to their conclusions, but to the thought process. So thoughtful discussion, worrying about being wrong but not to the sense of being paralyzed. Or moving forward, but in the sense of trying to create discovery, to have an exchange. To go after the person who has the most different point of view, who is the most thoughtful, and then have a conversation to see their point of view. Whether a person could be both open-minded and assertive at the same time, that creates a discovery process. It creates a fabulous learning. That process itself reduces the probability of being wrong and produces a great deal of learning. People are so hung up on being right. Starting their discussion and deriving some sort of satisfaction if, at the end of the discussion, they were where they began the discussion. That doesn’t make any sense, because there’s not going to be any learning. So ego plays an important role in that. The people that feel like, ‘I’m good. I’ve got it,’ won’t learn. If you’ve got it, you won’t learn. So you have to get rid of this ego barrier, ‘I’ve got it’ thing.”

“You start to learn how people see things differently. And rather than just seeing how you see it, you go above that. You’re seeing that everybody is seeing things differently. It changes how you see things because it starts to make you think, how do I know I’m not the wrong one? You start to think, how do I collectively see? And it’s like being in a different color range. All of the sudden you see the full spectrum. When you start to realize that people are actually seeing in those [different] ways — that it’s a valid way of seeing, and that I need you and you need me — it gives you the evidence base that it’s okay to be different. The most important thing is to have humility, and to think about, how do I get the best decision? It doesn’t have to come from me. I just want it to be right, right? If comes from other people, that’s good. The greatest tragedy of mankind is people holding on to wrong opinions that could so easily be rectified and that are doing them harm because they’re making wrong decisions.”

B. Organizational politics. One advantage that Buffett and Munger have is that in many cases the “radically transparent” discussion is just between the two of them. Both Buffett and Munger have said that they sometimes disagree but have never had “an argument” that was hostile. They have also decided to focus on investing decisions that involve forecasts about microeconomics. In contrast, Dalio is engaged in macro investing and his supporting organization is far larger. Reuters describes what must be managed at Bridgewater as follows:

“Bridgewater manages about $160 billion, according to its website, and is known for a unique culture of ‘radical truth and radical transparency’ whereby intellectual conflict is encouraged to promote a meritocracy of ideas, avoiding traditional office politics. The culture is not for everyone. The firm is known for relatively high turnover among its roughly 1,700-person staff. An estimated 25 percent depart during the first 18 months of employment.”

The challenges associated with maintaining a culture like Bridgewater which is willing to incur the overhead of continuously providing feedback and utilizing it in decision-making in an idea meritocracy are significant. The number of connections between employees increases with the square of the number of involved employees, which has caused Dalio to come up with some unusual approaches to maintaining radical transparency like videotaping and making available to anyone almost all meetings and the use of Bridgewater designed baseball cards. It is precisely because what Dalio is doing at Bridgewater is so hard that Bridgewater’s alpha has been persistent. If doing what Bridgewater does was easy, the alpha would disappear. Being different is a source of competitive advantage. If you want different results you must act in a different way.

To see how Dalio tries to combat dysfunctional corporate politics at Bridgewater it is useful to examine how he describes his principles:

“Never say anything about a person you wouldn’t say to him directly. If you do, you’re a slimy weasel. Badmouthing people behind their backs shows a serious lack of integrity. It doesn’t yield any beneficial change and it subverts both the people you are bad mouthing and the environment as a whole. Next to being dishonest, it is the worst thing you can do at Bridgewater. Criticism is both welcomed and encouraged at Bridgewater, so there is no good reason to talk behind people’s backs. You need to follow this policy to an extreme degree to be in harmony with our culture. For example, managers should not talk about people who work for them without those people in the room.” “So every meeting is taped and made available for everybody in the company to look at. And all we have are conversations of, ‘What makes sense?” Everybody has the right to make sense of things. Now in that environment I get to see how differently people think. I realize how radically different people think.”  “This approach comes to life at Bridgewater in our weekly research meetings, in which our experts on various areas openly disagree with one another and explore the pros and cons of alternative views. This is the fastest way to get a good education and enhance decision-making. When everyone agrees and their reasoning makes sense to me, I’m usually in good shape to make a decision. When people continue to disagree and I can’t make sense of their reasoning, I know I need to ask more probing questions or get more triangulation from other experts before deciding. I want to emphasize that following this process doesn’t mean blindly accepting the conclusions of others or adopting rule by referendum. Our CIOs are ultimately responsible for our investment decision-making. But we all make better decisions by maintaining an independent view and the conflicting possibilities in our minds simultaneously, and then trying to resolve the differences. We’re always in the place of holding an opinion and simultaneously stress-testing the hell out of it. Operating this way just seems like common sense to me. After all, when two people disagree, logic demands that one of them must be wrong. Why wouldn’t you want to make sure that that person isn’t you?”

This sort of total honesty and transparency is not a comfortable environment for many people, but it is for enough talented people that Bridgewater has been able to assemble its team and compile its remarkable investing record. If you want to dig into radical transparency and issues like how ego and emotions can get in the way of Dalio’s approach to making decisions, I suggest you watch “The Culture Principle” video linked second in the Notes below.


Dalio Essay

The Culture Principle

Dalio Interview:

Bridgewater Principles:  and

New Yorker Profile:

A Dozen Things Essay by me about Dalio:

Radical Transparency Essay:

The Rise of the Freemium Business Model


Freemium describes a business model in which a business gives one product away for free or at a subsidized price and then either: (1) sells another profitable product to this user base; or (2) sells access to that user base to third parties (e.g., advertisers). Three versions of the Freemium approach are:

  1. Available Forever- No premium versions are made available. Google and Facebook are examples that monetize with advertising.
  2. Premium Freemium: Users pay only for premium versions (e.g., more powerful features or greater use rights). Only the free baseline version is “available forever.” LinkedIn and TurboTax are an examples.
  3. Limited Freemium: The free version is made available but is limited by factors like time and/or capacity. One example would be a 30 day trial with no “available forever” baseline version.

The freemium business model is ancient. A bar giving away salty snacks to sell more  alcohol is nearly as old as the still that created the liquor. The practice of offering tapas in Spain is just one relatively modern example. Newspapers being used to sell political views is another example:

“Gerald J. Baldasty’s book, The Commercialization of News in the Nineteenth Century, makes a case clear as spring water that hard news has almost never been a mass commercial enterprise. The American newspapers of the 1820s and early 1830s were creatures of political parties, edited by zealots. Essentially propaganda sheets, these newspapers were “devoted to winning elections …Many subscribers simply did not pay for their newspapers,” Baldasty wrote.  “In 1832, one North Carolina editor estimated that only 10 percent of his 600 subscribers had paid for the paper.”

Many businesses have offered free services (free month of HBO) or free trials (magazines). The Venture capitalist Tomasz Tunguz of RedPoint has written about why the freemium business model works so well:

“At its core, freemium is a novel marketing tactic that entices new users and ultimately potential customers to try a product and educate themselves about its benefits on their own. By shifting the education workload from a sales team to the customer, the cost of sales can decrease dramatically… freemium startups leverage usage data to improve their product. The large amount of users using the product enables A/B testing with statistical significance, a non-trivial strategic advantage. Marketing teams can sift through the data to understand market segmentation and funnel efficiency, and product management can parse the data to improve the on-boarding experience. Third, freemium startups gather information about their customer base to prioritize their sales efforts.”

The cost of educating the potential customer about the benefits of the product can be dramatically lower once a potential customer has used the product in the free setting. The need for advertising to create awareness is lower and any expenses associated with a paid salesperson or sales support engineer patiently explaining the product to a potential customer has been replaced by self-education. Freemium also leverages other human tendencies like reciprocity and inertia, which further lower the cost of sale. John Vrionis of Lightspeed Venture Partners describes the less costly and more effective freemium sales process:

“Evangelizing a new religion is hard work, and more importantly it is expensive. But that’s essentially what selling proprietary software is like. Conversely, selling bibles to a group of believers is a lot easier… Sales people engage an account when they know that the prospect is well down the path of adoption and belief.”

In some settings the salesperson can be eliminated completely as the customers “upsell” themselves with self-service capabilities of the company web site.

As Tungus and Vrionis note, the essence of the Freemium model is to reduce the price of acquiring a customer. My post “Why is Customer Acquisition Cost (CAC) like a Belly Button?” is an introduction to the topic of CAC. Everyone with a business has CAC.

To illustrate, even comedians must incur costs to acquire customers. As an example, here a famous few sentences from a monologue form the comedian Louis C.K:

“Everything is amazing right now and nobody’s happy. In my lifetime the changes in the world have been incredible. When I was a kid we had a rotary phone. We had a phone you had to stand next to and you had to dial it. And then when, if you wanted money you had to go in the bank for when it was open, for like three hours.”

Those four sentences solidified Louis C.K.’s reputation as an A-List comic. The comedian’s monetization was indirect as is often the case today:

“Comedians today are more likely to gain fame via a YouTube skit or a bit that plays well on a talk show. (Louis C.K.’s most famous monologue, “Everything’s amazing and nobody’s happy,” happened in a sit-down interview with Conan O’Brien).”

Since Louis C.K. is a member of the Screen Actors Guild he would have received at least the union minimum wage to be on O’Brien’s show, but that is a tiny fraction of the value that monologue created for his career. Louis C.K. essentially gave away that monologue for free. In this case one activity (the Conan O’Brien appearance) is being used as a substitute for customer acquisition cost (CAC) for other products like his concerts. This cross promotional approach is not new. Especially for comedians. Not too long ago they generated most of their profit from albums (promoted on talk shows) and concerts (Johnny Carson used to tell people their dates).

Are other comedians using freemium like Louis C.K.? Yep. But the loss leader is not always a zero revenue gig, just lower revenue.

“Comics [have] realized how a constant presence on Netflix, as opposed to sporadic broadcasts on linear television, could help build a larger loyal audience. For most comedians, specials are a means to boosting their key revenue source: regular ticket sales on the road. TV specials have always translated into additional fans showing up on tour stops, but the lift from a Netflix special exceeded what a lot of comics were seeing from regular TV. “The amount of time it took to see the bump was drastically reduced from years to … six or seven months after an artist’s special is on Netflix,” says Volk-Weiss. “Their touring business goes up by hundreds of [percent].”

Wait!” You are probably saying, “People have done free promotions forever.” That’s true, but with the digitalization and networking of the world this freemium phenomenon has been put on steroids. Ben Thompson succinctly describes one root cause of why the Freemium phenomenon is on the rise as a customer acquisition technique as the world become more digital and networked:

“The defining characteristic of anything digital is its zero marginal cost. Take apps for example: What makes the software market so fascinating from an economic perspective is that the marginal cost of software is $0. After all, software is simply bits on a drive, replicated at the blink of an eye. Again, it doesn’t matter how much effort was needed to create said software; that’s a sunk cost. All that matters is how much it costs to make one more copy – $0. The implication for apps is clear: any undifferentiated software product, such as your garden variety app, will inevitably be free. This is why the market for paid apps has largely evaporated. Over time substitutes have entered the market at ever lower prices, ultimately landing at their marginal cost of production – $0.”

In addition to being reproducible and distributable at virtually zero marginal cost, digital goods typically do not have the two qualities described here by Brad DeLong:

“Excludability: the ability of sellers to force consumers to become buyers, and thus to pay for whatever goods and services they use.

Rivalry: a structure of costs in which two cannot partake as cheaply as one, in which producing enough for two million people to use will cost at least twice as many of society’s resources as producing enough for one million people to use.”

If I make a digital copy of your digital music, you still have your music (the music is non-rival). If I steal your phone you will no longer have a phone (a phone is rival). So-called “public goods” are non-rival and non-excludable. A lighthouse is a public good and in many settings so is software. If a business can’t charge customers a fee directly for a good or service since it is a public good giving it away is “sleeves off its vest.” In other words, the real opportunity cost of the sales incentive is zero if the business can’t charge a fee for it anyway.

One confusing element of a freemium business model is the accounting involved. If giving away goods or services for free or with a subsidy is not a marketing expense, what exactly is it? Marketing costs are typically shown below the gross margin line on an income statement. But the cost of freemium offerings can be considered part of costs of goods sold or COGs. Different companies treat freemium costs in different ways. Some companies even split the difference: the cost of non-converted non-paying customers is a marketing expense and the cost of serving paying customers is COGS. In any event, giving away free services is an expense however you look at it.

Small startups with little cash on hand or that desire not to dilute their ownership too much by raising more cash have found freemium to be particularly attractive. If they know how to write software they can use the free service to avoid spending cash on customer acquisition. As an added benefit, customers acquired though freemium tend to value the product more. They churn less from the service and tend to have better credit. Of course freemium can be taken too far, especially if there isn’t a profitable complementary good that can be paired with the service. With internet scale services, while the incremental cost of a new customer/user is not zero (as per Ben Thompson’s description of digital goods) it is effectively zero as there is so little incremental cost. An exception would be highly resource intensive services such as live streaming, email/file storage, or translation all of which use significant bandwidth, storage, or compute per incremental use.

Bill Gurley describes an increasingly important phenomenon facing every business today: “If a disruptive competitor can offer a product or service similar to yours for ‘free’ and if they can make enough money to keep the lights on, then you likely have a problem.” Every businesses today must be prepared for competitors to give away what they sell as an incentive for customers to buy something else. That fact thatmany of the free services are digital and have close to zero marginal costs has caused the freemium strategy to spread like wildfire. The implications of the freemium business model are massive since businesses now face competition from companies that they never previously thought of a competitors. Fred Wilson believes: “when network effects matter, when your users are creating the content and the value, free is the business model of choice.” If the network effects benefits of size are large getting big fast is hard given customers acquisition cost. And the best way to lower customer’s acquisition costs is often free. Making the approach even more attractive is the fact that even free users add to network effects since they are using the systems and its formats.

Using a freemium approach can be tricky in an enterprise setting. Version One ventures points out that freemium can create problems and is not a panacea:

“Offering an app/service for free can send the wrong message. Here, free can be equated with low quality. Free isn’t necessarily sustainable with B2B. Acquiring business users may prove too costly, forcing start-ups to raise incredible amounts of money to finance aggressive sales and marketing efforts for a free app. In the enterprise, freemium models generally work in two situations: (1) You target a large enough user base and (2) The product becomes more valuable over time.”

Freemium works best when there are millions of potential customers since the conversion rate will not be high. Best practices include:

  1. Avoid selecting “free” items that have significant variable COGs. Select software-based free services that have almost zero marginal cost works better.
  2. The best free services have network effects.
  3. Make sure that the item you select as free side of the marketplace has complementary services that might be sold at a profit. Free checking at a bank is good example of free service that makes upselling natural (many types of loans).
  4. The best forms of Freemium make it natural for the users to register revealing their personal data and set up a credit card on file.
  5. The best complementary products are services that people are accustomed to paying real money for (convincing people to spend money in a new category is not easy),
  6. The best free services have low churn since they are sticky)

What sort of conversion rates are typical in a freemium model? One estimate from Totango is:

“For a B2B SaaS company with free trial, I assume the following ball park figures:

3%-5% – average and means good business operations
8% and above – excellent conversion rates
below 3% – below average.”

Nothing creates a base from which to try to up-sell users like a free service.  There is no question that a price of zero is magical for humans. Work by Dan Ariely proves this point:

“In one study we offered students a Lindt Truffle for 26 cents and a Hershey’s Kiss for 1 cent and observed the buying behavior: 40 percent went with the truffle and 40 percent with the Kiss. When we dropped the price of both chocolates by just 1 cent, we observed that suddenly 90 percent of participants opted for the free Kiss, even though the relative price between the two was the same. We concluded that FREE! is indeed a very powerful force.”

Ariely concludes: “‘Free’ is kind of an incredibly tempting human hot button. And sometimes it’s great and sometimes it gets us into trouble.”   

The freemium approach is now scalable globally as never before. The implications of this shift are huge and still being sorted out.

P.s., How much is being given away by producers in consumer settings as a result of the freemium phenomenon? Since free products have no price they are not easy to measure, One indication that the number is large is the fact that 98% of App Store revenue is coming from freemium apps. Services like mobile games and Craigslist have free elements.

  • A Deloitte Report summarizes some of the research in consumer settings:

“Researchers at the University of Michigan found that they saved 15 minutes by using the internet compared to the university library to answer a list of specific questions. Assigning a monetary value to these time savings Google’s Chief Economist, Hal Varian, estimated that the search feature of the internet generates a consumer surplus in the US of $65-130 billion a year. This is likely to significantly underestimate the true level of saving because in this experiment the internet was compared with a university library – an asset that few consumers can access. Another approach is to estimate the time people spend on the internet. The reasoning runs that if I choose to spend an evening searching the web it demonstrates that I prefer this activity to all others available to me. Using this approach Erik Brynjolfsson and Joo Hee Oh at MIT estimated America’s consumer surplus from the internet at $564bn in 2011. Inclusion of this surplus in America’s GDP numbers would have boosted annual growth by a sizeable 0.4 percentage points – equivalent to a 15% uplift in trend growth.  The nature of the internet and the way we interact with it makes estimating the consumer surplus from it incredibly difficult. Crowdsourced websites such as Twitter, Wikipedia, TripAdvisor or the review section of Amazon are particularly challenging. How does one measure the addition to the consumer surplus from our receiving advice, ideas and information?”

These estimates do not include the value of open source and other public goods for businesses such as free cloud compute and storage for commercial customers. For example, every cloud company now has a free tier. Azure also has free credit for new customers and a free service trier.  Amazon has both an always free trier and a first-12-months-free offer. Google also has a free to use tier for its cloud services. In 2015 GetApp, a company that tracks over 3,000 business apps, reported that 22% of the total have adopted a freemium model. Business like DropBox, Slack, MailChimp, SoundCloud, EverNote, ZoHo, SurveyMonkey, Skype, HootSuite, Moz, Weebly, Salesforce, Optimizely, and Box all use a freemium approach. Open source examples include Linux, Git, MySQL, Node.js, Docker, Hadoop, Elasticsearch,  Spark,  MongoDB, Selenium, NPM, Redis,  Tomcat, Jenkins, Vagrant, Postgres, Gradle, Nginx, Ansible,  Kafka, GitLab, and Chef.

Open source software has enabled the creation of many freemium business models. By combining software that is given away as part of an open source community with related proprietary services that are not given away, a new business model is created. The related profitable and proprietary services must “complement” the free service like mustard complements a hot dog for the model to work well. Many entrepreneurs and investors have realized that the best path in creating a new business is to invent an open source project that is widely contributed to and then build a service around it after hiring all the people who worked on it. Businesses that have been built around open source, like Databricks, Mesosphere, and Docker, exemplify this trend.


Louis C.K.

Ben Thompson



John Vrionis:

Jack Shafer: News never made money, and is unlikely to.

Tomasz Tunguz

Version One:

Fred Wilson:

A Dozen Lessons about Business Valuation from the Iridium Debacle


One of the best illustrations of the many ways a business valuation can go wrong is the pre-bankruptcy story of mobile satellite service Iridium. I knew Iridium  well since I did potential acquisition due diligence on Iridium several times and because people who worked for Craig McCaw had a long history with Motorola. We (Eagle River) always passed on buying Iridium no matter how low the price dropped. The potential upside of buying Iridium even for $1 was tiny, but the potential downside (especially the opportunity cost) was massive. We already had enough wholesale transfer pricing and other problems with Motorola related to Nextel.

There is a recent book about Iridium, but that account does not identify why such colossal mistakes were made in assessing the potential value of the business. The common narrative is:

“John Bloom, an investigative journalist and author of the book Eccentric Orbits: The Iridium Story. “It did what it was supposed to do. It was an engineering miracle. It’s just that not enough people needed a phone at all longitudes and latitudes.”

That’s true only in that not enough people valued the product at the price point. But there are deeper explanations of why this happened. The common explanation is that “cellular spread faster than people imagined.” That wasn’t the root cause.

The root cause of Iridium’s valuation failure was what I call goal seek bias which is a special case of confirmation bias and incentive caused bias. The goal seek function in a spreadsheet allows a modeler to use the desired result of a formula to find the possible input value necessary to achieve that result. To understand how the biases played out in the case of Iridium you must know a few background facts.

Motorola was a satellite subcontractor. It wanted to be a prime contractor, but it did not have a customer. The best way around that problem was to create the customer for Motorola satellites from scratch. Iridium was born for that reason. In order to raise the billions of dollars needed to pay for the system a credible business model was required. Naturally spreadsheets were created and it was necessary to goal seek a total addressable market (TAM) to financially justify building and operating the system to investors. The outcome of that financial modeling was a case of what Warren Buffett calls the institutional imperative at work:  “Any business craving, however foolish, will be quickly supported by detailed rate-of-return and strategic studies.”

The result of the goal seek bias in the case of Iridium was preposterous on its face, if the assumptions were carefully examined.

The phone did not work indoors

The phones did not work in a car

The phones did not work without line of sight to the satellite (buildings and even trees are a problem)

The phones were very big, heavy and expensive

The service was expensive

What did the market researchers ask potential consumers about the Iridium service? A classic leading question of course: “Would you value a mobile phone that you could use anywhere?”  Who wouldn’t say yes to that question? But it wasn’t even close to the right question to ask.

The reality was “anywhere” meant: to use the Iridium service a person would need to find an open field and lug out a heavy and expensive phone and pay expensive rates. That isn’t anywhere. Anywhere means inside buildings and cars or in the shadow of a buildings. On a mountainside is a place but is not enough to mean anywhere and instead is a niche market. My friend and wireless expert Tim Farrar sent this Tweet on the topic:


Goal seek bias ignored this reality and that resulted in a number of silly estimates from forecasters about the size of the mobile satellite market. For example:


The way confirmation bias works inside a company like Motorola meant that the problems with the addressable market I just discussed were rendered invisible and the momentum enabled by social proof (“Hey lots of big companies are behind this”) enabled the system to be built.

“In order to secure bank loans in early 1999, the following subscriber targets (“covenants”) were set for Iridium: 52,000 by March 31, 1999; 213,000 by June 30, 1999 and 454,000 by September 30, 1999. Even though never publicly disclosed, the break-even point for Iridium was expected to be between 500,000 and 600,000. In order to reach this level, Iridium would have had to add roughly 50,000 subscribers per month in 1999. In reality, in March 1999, Iridium only had 10,000 subscribers. The number of three to six million subscribers expected by 2001 was never reached. A comparison between the predicted subscriptions and reality is shown in Figure 12”


The end result was both tragic and relatively swift:

On November 1, 1998, after launching a $180MM advertising campaign and an opening ceremony where VP Al Gore made the first phone call using Iridium, the company launched its satellite phone service, charging $3000 for a hand-set and $3 – $8 per minute for calls.  The results were devastating.  By April 1999, the company had only ten thousand subscribers.  Facing negligible revenues and a debt interest of $40MM per month, the company came under tremendous pressure.  In April, two days before Iridium was to announce quarterly results, CEO Staiano quit, citing a disagreement with the board over strategy.  John Richardson, an experienced insider, immediately replaced Staiano as interim CEO, but the die was cast.  In June 1999, Iridium fired 15% of its staff, including several managers who had been involved in designing the company’s marketing strategy.  By August, Iridium’s subscriber base had grown to only 20,000 customers, significantly less than the 52,000 necessary to meet loan covenants.  Two days after defaulting on $1.5 Billion in loans – on Friday, August 13, 1999 – Iridium filed Chapter 11 bankruptcy protection.

Iridium was purchased by an investment group for very little cash and today is both an operating business and a listed company. The business is very different than originally envisioned (r.g., they are chasing non voice markets) and the link to Motorola that would have created huge wholesale transfer pricing problems is gone (Iridium has multiple suppliers). The prospects of that new business is not a subject covered in this post since this is about what happened pre-bankruptcy.

What are “the dozen lessons” in the case of Iridium?

  1. “An unresolved contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable.”  “A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. Real businesses, even the best ones, are unfortunately not annuities.” Seth Klarman

When valuing an asset it is wise to focus of the simplest system possible, preferably one that has a stable and well known operating history (e.g., an individual business  like See’s Candies).  Iridium was about as far from an annuity as was possible. When valuing a business like Iridium a massive margin of safety must be built into the model to account for risk (risk meaning the potential for a permanent loss of capital). How are risky investment intelligently made? Well, very carefully. A portfolio approach is used in venture capital since only a very small number of outsize winners determine the financial outcome of a given fund. Warren Buffett describes the strategy adopted:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

  1. “When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately, future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task. Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. A recurring theme in this book [Margin of Safety] is that the future is not predictable, except within fairly wide boundaries.” Seth Klarman. 

Klarman is pointing out a fact that will be made repeatedly in this post.  A NPV calculation of the value of a business is not precise. This means that having a margin of safety is wise. Everyone makes errors and mistakes and so having insurance against those mistakes is wise.  With a margin of safety you can be somewhat wrong and still make a profit.  And when you are right you will make even more profit than you thought. I have written posts before about the discount rate issue.

  1. “Using precise numbers is, in fact, foolish: working with a range of possibilities is the better approach.” “Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure.” Warren Buffett  “Warren talks about these discounted cash flows. I’ve never seen him do one.” Charlie Munger.

Warren Buffett’s response when Charlie said this was to say:  “It’s true. “If the value of a company doesn’t just scream out at you, it’s too close.” “You just want to estimate a company’s cash flows over time, discount them back and buy for less than that.” Warren Buffett “In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Warren Buffett in the Berkshire 2000 annual report.

  1. “In 44 years of Wall Street experience and study I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra.  Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience.” Ben Graham

Some people are seduced by Greek letters in valuation formulas. Seth Klarman has said: “It is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.”

  1. “DCF is an unruly valuation tool for young companies. This is not because it is a bad theoretical framework; it is because we don’t have accurate inputs. Garbage in, garbage out.”  Bill Gurley

Whenever you receive a spreadsheet valuing a business, it is wise to focus on the assumptions. And as Gurley points out that is particularly true of a young company. But people make emotional mistakes:

“Ed Staiano, formerly a senior executive at Motorola and the CEO of Iridium at the time of commercial activation, knew in intimate detail how the Iridium system actually functioned and was well aware of its various technical limitations, including the fact that the Iridium telephone would not work dependably indoors or in the urban canyons of central business districts, but he made the decision, nonetheless, to invest $500,000 of his own money in Iridium securities in March 1999”

“Multiple witnesses indicated that they were familiar with the “line-of-sight” nature of the system, and, despite that, they appear to have assumed that the service still would be acceptable to users.”

Iridium is a particularly extreme example of garbage in and garbage out. Sometimes people suspend disbelief:

NEW YORK-Iridium World Communications Ltd., which plans to launch a satellite-based global telephone and paging service, went public June 10, raising $240 million in an offering of 12 million shares of Class A common stock at $20 per share. The initial public offering, lead managed by Merrill Lynch & Co., New York, was oversubscribed. Consequently, the issuer, which had planned a 10 million share IPO, increased its initial offering by 2 million shares.

  1. “Buffett’s reluctance to invest in technology businesses “is not a statement that technology stocks are unanalyzable.” Robert Hagstrom in his book The Essential Buffett: Timeless Principles for the New Economy.

Buffett says: “We have no religious belief that we will not invest in tech, just can’t find one where we think we know what the bush will look like in ten years or how many birds will come out of the bush.” Both Munger and Buffett have said that if they were young today they would acquire a technology circle of competence. But they are not young today. What they are looking for is an unfair advantage when they invest and in high-technology they have no such advantage.

  1. “Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision.  They do that in business schools, because they’ve got to do something.” Charlie Munger.

That a spreadsheet generates precise numbers can create an illusion of precision. It is one of several biases that can impact a valuation. Aswath Damodaran:


Multiple bias and illusions were involved in this result:

“The Global Arrangers for a $1 billion credit facility that  closed in December 1997 engaged Coopers & Lybrand (now known as PriceWaterhouseCoopers) and Arthur D. Little to conduct extensive independent diligence with respect to the Iridium business plan as a condition to extending credit to Iridium. These consultants to the lenders “stress tested” the Iridium projections, prepared a more conservative set of projections that assumed a downside case for future company performance after commercial activation and gave a green light to the loan which was oversubscribed.”

  1. “I have seen so many cases where there is a complex model that is exactly wrong.  This focus on a model may cause you to move away from thinking about the competitive advantages of the business. Then you are making decisions based on all these numbers rather than thinking about whether this is one of the ten businesses that you would like to own.” Glenn Greenberg.

Numbers can seduce even the most rational investor. It is qualitative factors that generate quantitative results in a business. Does the business have a sustainable competitive advantage? This can be tested for existence using numbers but it cannot be analyzed by just using numbers. Competitive advantage is determined qualitatively. Mohnish Pabrai make the point in this way: “It’s not about the numbers.  For most investments the factors that will drive long term success don’t have much to do with spreadsheets.  They have to do with something other, either understanding human nature or understanding nuances about how certain aspects of how things work rather than running spreadsheets.”

  1. “So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.” James Montier.

Take company X and its market cap. What sort of growth would be required to support that valuation? For Iridium:

May 1998: Full satellite constellation in orbit, stock peaks at $68 7/8 with Iridium’s total market capitalization near $10 billion

Paraphrasing Buffett: “Think about a company with a market cap of $10 billion. To justify paying this price, you would have to earn $1 billion every year until perpetuity, assuming a 10% discount rate. Think about how many businesses today earn $1 billion, or $.75 billion, or $.5 billion. It would require a rather extraordinary change in profitability to justify that price.”

  1. “Some investors swear off the DCF model because of its myriad assumptions.  Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple.  Multiples are not valuation; they represent shorthand for the valuation process. Like most forms of shorthand, multiples come with blind spots and biases that few investors take the time and care to understand.” Michael Mauboussin.

Aswath Damodaran:

“Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when

  the objective is to sell a security at that price today (as in the case of an IPO)

  investing on “momentum” based strategies

With relative valuation, there will always be a significant proportion of securities that are under valued and over valued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens)”

From January 1998 to January 1999 a great Number of analysts believed that Iridium had an equity value that ranged between $4 and $14 billion. Garbage in and garbage out.

July 1997: DLJ gave Iridium a $6.2 billion private market equity valuation.

October 1997: BancAmerica Robertson Stephens gave Iridium a $9.3 billion private market equity value.

February 1998: Goldman Sachs found $10.6 billion private market equity value.

  1. “Though many DCF models do incorporate sensitivity analysis (typically a grid of values driven by alternative cost of capital, growth, or terminal valuation assumptions), these grids provide little relevant information for anyone trying to understand the prospects of the business. Investors should look to the value drivers—sales, margins, and investment needs—as sources of variant perception. Even sensitivity analysis based on the value drivers is generally flawed because it fails to consider the interactivity between value drivers. Proper scenario analysis considers how changes in sales, costs, and investments lead to varying value driver outcome.” Michael Mauboussin 

Sensitivity analysis is useful in getting a “feel” for a business model. What inputs are most important? Even with a sensitivity analysis since the systems involved are complex and adaptive, scenario analysis is important. Maboussin writes: “Scenario analysis also addresses concerns about an uncertain future. By considering “if, then” scenarios and insisting on a proper discount to expected value—or margin of safety—an investor can safely and thoughtfully weigh various outcomes.

  1. “Generally, when companies or investors run a cash flow model they go out five or ten years. Why is that? Because that’s how many fingers you have. Literally, we live in a decimal world because that is how many fingers we have! What you really want to do is link the competitive position of your business and/or industry to an economically sound competitive advantage period.” Michael Mauboussin 

It is always best to read Mauboussin in the original.







Aswath Damodaran  and

Bonus round:

“I agree with Warren to keep it simple and not use higher mathematics in your analysis.” Walter Schloss

“In my life there are not many questions I can’t properly deal with using my $40 adding machine and dog-eared compound interest table.” Charlie Munger

“A person infatuated with measurements, who has his head stuck in the sand of the balance sheet, is not likely to succeed.” Peter Lynch

“Any attempt to value businesses with precision will yield values that are precisely inaccurate.”

“We never sit down, run the numbers out and discount them back to net present value … The decision should be obvious.”  Charlie Munger

“It is better to be approximately right, than precisely wrong.” Warren Buffett

“There’s no such thing as precise intrinsic value.” Mohnish Pabrai

“There are so many factors involved that it is never wise to attempt to judge intrinsic value to the last eighth or even point.” Phil Fisher

“Given that the future is inherently uncertain, we do not believe the value of any business can be known with certainty at a given point in time, so our aim is to be generally right as opposed to precisely wrong.”  Wally Weitz

“It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions” Jean-Marie Eveillard

“Businesses, unlike debt instruments, do not have contractual cash flows. As a result, they cannot be precisely valued as bonds” James Montier

“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It need only establish that the value is adequate.” Ben Graham

“If modest changes in assumptions cause a substantial change in NPV, investors would be prudent to exercise caution in employing this method of valuation.” Seth Klarman

A Dozen Lessons about Business, Investing and Money from Lil Wayne (Weezy)


1. “They can’t put no more Weezy baby out. That’s that cash money vasectomy.” From the song: Grateful.

That there was a feud between Lil Wayne and Birdman and another feud with the record label which has distributed Weezy’s music is well known. The core of the issue is “wholesale transfer pricing” (WTP).  Simply put:  WTP is the bargaining power of A that exclusively supplies a unique product X to B which may enable A to take the profits of B by increasing the wholesale price of X.  In this case, the artist (Weezy) is unhappy about by the nature of the revenue split between himself, Cash Money Records and the distributor. The good news is that industry revenue are rising:

The outbreak of streaming has officially helped the music industry rebound after nearly a decade of decline, with the Recording Industry Association of America reporting $7.7 billion in revenue in 2016. That’s the music industry’s highest gross since 2009 and, at an 11 percent improvement over 2015, its best gains percentage-wise since 1998.”

ria rev

2.”The garden’s full of snakes so I had to escape.” From the song: CoCo.

What relative WTP determines is the structure of what is called an industry profit pool,  which is the total amount of profit earned in an industry at all points along the industry’s value chain. The amount of sustainable profit generated by any business is driven by whether it has a moat and the definitive essay on moats was written by Michael Mauboussin. In that essay he writes:

“A profit pool shows how an industry’s value creation is distributed at a particular point in time. The horizontal axis is the percentage of the industry, typically measured as invested capital or sales, and the vertical axis is a measure of economic profitability… Profit pools are particularly effective because they allow you to trace the increases or decreases in the components of the value-added pie. One effective approach is to construct a profit pool for today, five years ago, and ten years ago and then compare the results over time.”

Mauboussin created this profit pool example which illustrates how some firms can be profitable and others not in the same value chain:


“the industry as a whole destroyed an average of $19 billion of shareholder capital per year through the 2002-09 business cycle”

The nature of a given profit pool can change over time or not. For example, someone can argue that new developments, like the recent reduction the number of airlines has changed the situation now and profit for airlines may be more sustainable. That is true but that is not relevant to the 2002-09 time period in the chart. One really interesting fact about how the airline industry has changed and how its profitability prospects may have improved is the rising importance of selling airline miles.

Bloomberg reports:

“the sale of miles—mostly to the big banks, but also to companies that range from car rental firms to hotels to magazine peddlers. The latter has expanded so much that it accounts for more than half of all profits for some airlines. [one estimate] is that the margin on this business is 60 percent or 70 percent.”

Profit in a business does not always arrive directly. Weezy knows that. The fact that certain complementary goods exist that can lower factors like CAC and churn can create a really important dynamic when a company adopts something like a freemium/land and expand strategy. For example,

“Credit Karma, a popular credit-monitoring site, wants to do your taxes online for free. [Kenneth Lin’s company is] striking out at TurboTax and H&R Block, which are now charging the typical homeowner or investor more than $90. Credit Karma can offer free tax preparation because it makes money in other ways. The company, with 600 employees, gets paid to recommend financial products, such as credit cards and auto loans, to customers. It says it had revenue of $350 million in 2015 and has been profitable for a couple of years. By breaking into tax prep, Credit Karma hopes to get better data on its members and improve its recommendations. The idea is to create a “trusted digital assistant” for its customers’ financial lives, Lin said.”

As another example, look at the Comcast mobile offering. One of Comcast’s major goals with the wireless service is to reduce churn for the overall bundle of services.“The more products you add, the lower the churn,” said Greg Butz, president of Comcast Mobile.  That lower churn alone can justify the effort. Or not. That depends on the unit economics which we do not know.  Comcast will only sell the mobile service to customers who are already buying its broadband offering (that lowers CAC and COGS; as always everything in lifetime customer value is connected and has reflexivity).

The impact of this freemium/land and expand phenomenon is highly underestimated since it is happening many categories.  The consumer surplus created as these strategies are implemented is massive but so is the producer surplus it eliminates.  The end result is great for consumers but a challenge for businesses that have counted on the revenue to generate profits, not just product promotion. In this way the cost of goods sold (COGS) in many categories is being transformed unto CAC by companies implementing a form of the freemium/land and expand strategy adopted by Credit Karma. In a profile of Bill Gurley I quoted him (in bold) and then wrote:

“If a disruptive competitor can offer a product or service similar to yours for “free,” and if they can make enough money to keep the lights on, then you likely have a problem.” Digital offerings have very strange economics in that multi-sided markets are often involved and offerings in such a market can have close to zero marginal cost once it has been created. Solving the “chicken and egg” problem inherent in any platform business usually involves either a free egg or free chicken on one “side” of the market.  It’s easy to wake up in a digital world and have whatever you were selling now being offered “for free.”

The profit pool in the music industry is not something Weezy is happy about since he believes his share should be bigger. He once said in an interview:  “I want off this label and nothing to do with these people, but unfortunately it ain’t that easy.”

The most important aspect of a profit pool analysis is that it is not just a statement about the top line revenue of a business. Revenue is not profit! It is odd that this even needs to be said, but I am doing so anyway. Too many people think: “Well this business in generating a lot of money!” The assumption is that it must be profitable or is generating the most profit in the value chain, when that is not the case. Music streamers may have a lot of revenue and yet zero profit.  That’s why a profit pool analysis is so interesting.

spot mar

Here’s another example created by Mauboussin:


Mauboussin’s profit pool graphics illustrate that some sectors of some industries generate huge amounts of value for society and yet no overall profit. This is also true about innovation. Sometimes all of the benefits of an innovation go to consumers. As an example, Bill Gates said once:

“If you look at an industry where you have such a rapid increase in supply, usually that’s pretty bad, like when radial tires were invented, people didn’t start driving their cars a lot more, and so it means the need for production capacity went way down, and things got all messed up.  The tire industry is still messed up. Supply is the killer of value. That’s why the computer industry is such a strange industry.  We’re dealing with amazing increases in supply.”

Sometimes disruption only benefits consumers and producers end up with nothing. Whether something is “disruptive” does not determine whether it may be a direct source of profit for the producer.  This increase in the rate at which producer surplus is transformed into consumer surplus also distorts all sorts of economic statistics like GDP.

3. “If Cash Money Records coming for me, I’m goin’ out like Tony.” From the Sorry 4 the Wait 2 mixtape.

Lil Wayne has considerable leverage in these WTP disputes since, among other things, he is needed to promote the product. He has been able to maintain some leverage for that reason and that so far has produced a stalemate. Lil Wayne’s suggestion that he would rather go out like Tony Montana did the 1983 film Scarface is an often seen negotiation  tactic. In an interview Weezy noted: “Carter V is super-done. Cake baked, icing on top, name on top, candles lit. I would have released it yesterday if I could. But it’s a dead subject right now. It’s a jewel in the safe. It’s that stash-house money.”

4. “Right now, anybody could put out a new song on the Internet and it could become the hottest thing ever. When I was starting, you couldn’t do that type of shit. But that’s wonderful – the game is wide open, and my job is just to stay vital.”

The internet has been a destroyer of many moats that were based on distribution scarcity (for example newspapers and music). People like Weezy have had to increasingly make their profits on concerts and merchandise. I discussed this in my post on Louis CK, Biggie and Rza. Even at Universal mech is a significant revenue line as is streaming:


5. “I got the key to success, get money invest.” From the song: Over Here Hustlin.

Lil Wayne understands that it is income from services and other work (“get money”) that enables investments. Investments are certainly important, but so is a source of income which is fundamental, especially for younger people.

6. “I’m just chillin, but my money still running ’round.” From the song: Over Here Hustlin.

Lil Wayne is channeling Warren Buffett with this lyric, who once said:If you don’t find a way to make money while you sleep, you will work.” The best way to earn money while you sleep is to invest wisely.

7. “My money so old I tell my new money ‘respect your elders.’”From the song: Living Right.

It is not completely clear what Lil Wayne is talking about in this lyric, but it is possible he is referring to the fact that older assets tend to have a lower tax basis and deserve respect. To lower the tax hit, new assets should be sold first to raise cash for expenses like VIP sessions at clubs or private jets.

8. “I need a Winn-Dixie Grocery bag full of money.” From the song: Got Money. “I gotta posse full of hittas and a pocket full of In God We Trust; It’s been so long since I said “it cost too much.” I’m so addicted to the fast money lifestyle and withdrawal sucks; And dead presidents act immortal, but I know you see money’s not a problem” From the song: “I Feel Good”

People tend to acquire significant hobbies and other habits that require involve significant cash burn rates. Lil Wayne is saying that this can create problems unless you have a lot of cash. For example, as well all know the only unforgivable sin in the VIP section of the club is to run out of cash. Lil Wayne seems know the Warren Buffett admonition well:  “Nothing sedates rationality like large doses of effortless money.” So having a grocery bag full of cash is helpful.

9. “I invest, I stock trade, From Eagle Street, to Wall Street.” From the song:  Hot Boy (Freestyle)

It appears that Lil Wayne is an active stock market investor. He may hold some passive investments in Vanguard and other funds and ETFs but it is not clear from the context of this song lyric. Some people can invest in an active way successfully, but not too many. Charlie Munger believes that ~3% of investors can do so.

10. “Getting mugged from everybody you see.”  From the song: Got Money.

Lil Wayne in this lyric is agreeing with the Charlie Munger idea that jealousy is a worthless emotion. Munger points out: “A member of a species designed through evolutionary process to want often-scarce food is going to be driven strongly toward getting food when it first sees food. And this is going to occur often and tend to create some conflict when the food is seen in the possession of another member of the same species. This is probably the evolutionary origin of the envy/jealousy tendency that lies so deep in human nature. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”

11. “Real Gangsta’s die of old age.” From the Song: Cream.

As Hyman Roth said in the movie The Godfather: “Good health is the most important thing. More than success, more than money, more than power.” In keeping with Mr. Roth’s admonition Lil Wayne appears to want to take better care of his health. I need to do that too.

12. “Soon as I learned how to talk I talked business.” From the song: Cream.

In another blog post entitled “A Dozen Things I’ve Learned About the Music Business (and Businesses Like It)” I quote Kurt Cobain as saying: “I wish there had been a music business 101 course I could have taken.” Lil Wayne is saying he learned about business very early in life. That was a good idea. As Warren Buffett likes to say: “I am a better investor because I am a businessman, and a better businessman because I am an investor.”






Should Tax Preparation Be Free? Credit Karma Challenges TurboTax – Bloomberg

25IQ Gurley

25IQ Music

Comcast Wireless and


A Dozen Beliefs About Business, Money and Life that Kanye West Shares With Other Great Entrepreneurs and Investors

1.“For me, first of all, dopeness is what I like the most. Dopeness. People who want to make things as dope as possible, and, by default, make money from it.”

As everyone who is dope knows, “dopeness” is an adjective used to describe the awesomeness of a person, place or a thing. In these sentences Kanye is in effect repeating the Y Combinator motto as stated by Jessica Livingston: “Make something that people want. If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.” Kanye understands that the establishing the “value hypothesis” (finding product/market fit) must precede the “growth hypothesis.”

2. “Please avoid trying to talk me out of being me in the future.”

Kayne wouldn’t be interesting if he wasn’t Kanye. In making this statement about “me being me” he is channeling a point made by people like Bill Gurley about the importance of sometimes being a contrarian if you want to outperform a market. Gurley has said in this point: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.” Andy Rachleff agrees: “What most people don’t realize is if you’re right and consensus you don’t make money. The returns get arbitraged away. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”

3. “One of my biggest Achilles heels has been my ego. And if I, Kanye West, can remove my ego, I think there’s hope for everyone.”

Kayne recognizes in these sentences a point made Howard Marks: “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”  Paul Tudor Jones feels the same way: “Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”  Phil Fisher had a similar view:  “There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us.”

4. “If you read books – which I don’t, none at all – about how to become a billionaire, they always say, ‘You learn more from your mistakes.’ So if you learn from your mistakes, then I’m a f*cking genius.”

This statement about the importance of learning from mistakes is straight up Charlie Munger: who has made these same points about mistakes which are quite similar to Kayne’s thesis: (1) “There’s no way that you can live an adequate life without many mistakes.” (2) “Of course, there’s going to be some failure in making the correct decisions. Nobody ‘bats a thousand.’” (3) “I don’t want you to think we have any way of learning or behaving so you won’t make mistakes.” Munger is a self-described “book with legs sticking out” and reads constantly.  But he would never read a book about how to become a billionaire. 

5. “Having money isn’t everything, not having it is.” 

In my blog post abut what you can learn from comedians I pointed out that Johnny Carson once said: “The only thing money gives you, is the freedom of not worrying about money.” Kayne seems to understand why Seth Klarman said: “The trick of successful investors is to sell when they want to, not when they have to.” People who don’t have cash can be forced to sell other assets when they do not want to. Cash is always valuable, but there are times in the business cycle when cash is particularly valuable and planning ahead for those times is wise.

6. “I just have to look at say, ‘What do I have to lose? We only have everything to gain.’”

Kayne is thinking like Nassim Taleb on the value of convexity: “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).”  Sam Zell said something very similar in a New Yorker profile: “Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” This statement from Kanye is all about the value of seeking positive optionality. Every once in a while, if you are looking hard for opportunities, you will find a mis-priced bet within your circle of competence with a relatively capped downside and a huge potential upside. 

7. “Visiting my mind is like visiting the Hermès factory. Sh*t is real.” 

Kanye appears to be comparing himself to certain hedge fund founders in terms of his self-appraisal of his own IQ.  Many hedge fund greats are unabashed fans of their own mental competence like Kanye. John Bogle pointed out the dangers of overestimating one’s own IQ when he said: “We all think we’re above average investors just like we all think we’re above average dressers, I suppose, above average intelligence. Probably we all think we’re above average lovers for all I know.”

8. “I am so credible and so influential and so relevant that I will change things.”

Kanye is channeling George Soros on reflexivity.  Soros believes: “Markets can influence the events that they anticipate. Markets and the views of people about markets interact dynamically in their effect on each other. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner.” Kanye understands that people almost never make decisions independently. Duncan Watts writes: 

“when people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object {like Kanye] happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory….n such a world, in fact, the question “Why did X succeed?” may not have any better answer than the one given by the publisher of Lynne Truss’s surprise best seller, “Eats, Shoots & Leaves,” who, when asked to explain its success, replied that “it sold well because lots of people bought it.””

9. “I’ve gotta get my money up to another level cause it ain’t on Jay Z level, it ain’t on Diddy level yet. I’m talking about economic empowerment because the economics give you choices, the choices can help give you joy and freedom. And I’m trying to find that joy.”

Kayne seems to be talking about issues that Bruce Berkowitz identifies in this quote: “Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.” In my blog post on what you can learn from comedians I note that Chris Rock once said: “Wealth is not about having a lot of money; it’s about having a lot of options.”


10. “I think business has to be stupider. I want to do really straightforward, stupid business — just talk to me like a 4-year-old.”

Kanye is advocating the same game plan Warren Buffett does here:We try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows.”  Risk comes from not knowing what you are doing and keeping it simple lowers risk for that reason.Business is hard. Vanity Fair notes about Kanye’s business efforts so far:  

“In 2009, he put all of his musical endeavors aside to work on his label, Pastelle—which then shuttered after seven months. Add to that however much it cost to create his line of G.O.O.D. merchandise, marketed to fans of his record label. He was chewed up and spit out for his attempt at a high-end women’s-wear line called Kanye West in 2011. The line never made it to stores.”

Good judgement comes from experience and a lot of that come from bad judgement said Will Rodgers and hopefully Kayne is learning from his troubles as well all should.

11. “One of my courses was piano. I actually went to college to learn how to play piano. Talk about wastin’ some money.”

Kanye is expressing concern about the value of some aspects of college that he shares with Peter Thiel who has said: “I’ve never claimed that nobody should go to college or that we should shut down all the universities in this country or anything like that. What I have argued is that there is no one-size-fits-all, and that we need to have a more diverse array of things that people, including our most talented people, can be doing.” Learning should not start or stop with college.

 12. “My definition of success is dropping a Charlie Sheen-level tweet and being like, ‘I am in debt and f— you.’” “Also for anyone that has money they know the first rule is to use other people’s money.”

Kayne has probably not thought a lot about the ideas of Mike Milken. But Milken did once say something that Kanye should know:  “Debt isn’t good. Debt isn’t bad. For some companies, close to zero debt is too much leverage. For other companies, nearly 100 percent much higher levels of debt can easily be absorbed.” The same idea applies to people. As Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment which can result in “a permanent loss of capital.”

P.s., Kanye is Kanye, and I am not. Why is Tren writing about people like Kanye? First, I think you can learn something from everyone. Second, it is hard to get people to read anything about finance.  Adding someone like Kayne to the mix increase the number of people who will read the post. I can see it in the data. Why do I care about page views if I have no advertising or other business model?  As you may know I am fond of quoting Charlie Munger who once said: “The best thing a human being can do is to help another human being know more.” If people don’t read they can’t learn.

You may ask: “Why can’t Tren just write in a ‘seven simple rules for success’ format?  Unfortunately the world does not work that way.  A step-by-step formula for achieving wealth and happiness does not exist. Over the course of over 215 blog posts I have been advocating that readers adopt the “worldly wisdom” approach of  Charlie Munger which is based on the concept of a “lattice of mental models.” Your task, if you decide to adopt this approach, is to combine a range of mental models into a lattice and acquire “worldly wisdom.” A premise of the worldly wisdom approach is that there is no precise recipe for success. Munger instead suggests that individuals combine attributes like patience, rationality, cultivating optionality and aggressive opportunism. While the combination of attributes like patience and pouncing on opportunities may seem a bit strange at first, it is an approach that can lead to a highly favorable outcome. Munger says: “You’ve got to array your experience ‑ both vicarious and direct ‑ on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life.” By reading about the approaches of others and their successes and failures, you can begin to spot patterns that can help you make decisions in life. For example, you can do things like learn not to pee on an electric fence without doing it yourself. Be careful out there.


Duncan Watts:


Core Product Value and Entrepreneurial Success


I have previously written about Minimum Viable Product (MVP) and Product/Market Fit (PMF). These are important processes based on the scientific method that can be used to test a value hypothesis. That hypothesis does not just appear via spontaneous generation. Andy Rachleff describes what should be included in a value hypothesis as: “the features you need to build, the audience that’s likely to care, and the business model required to entice a customer to buy your product.”

At the center of any value hypothesis is “core product value” and the idea or vision behind that CPV is created by the entrepreneur.

As an example of how this process works and fits into a bigger picture, Chamath Palihapitiya’s approach has been depicted below by one of his colleagues:

top funnel

Core product value represents a solution a real problem that is valuable enough to cause people to want to pay for a product. Core product value is first recognized when the customer connects with the product in an A-Ha moment.

Core product value is an essential element of product/market fit which is a broader concept that requires additional elements. Andy Johns says: “For products that get the ‘magic moment’ and ‘core product value’ right, the top of the funnel naturally and rapidly fills.” in other words, without core product value and a magic moment it is not likely that people will convert from guests to customers. In a talk at Index Ventures Andy Johns talked about an example of what he feels is core product value:

“One current company with a clear core product value, Johns says, is Snapchat. Their core value isn’t just sexting as some like to believe; rather, it’s the removal of a designated target and mental friction from messaging. Users receiving snaps don’t have to worry about who else may be seeing a message or what their response is, and by removing that moment of hesitation, a social burden is lifted.”

You can disagree with his conclusion but I think even then you will understand his point. As another example, Johns believes that for Wealthfront, where he works now, core product value is giving any customer access to low-cost, tax-efficient, diversified investment portfolios via a direct to consumer model.

Finding a new source of core product value is: (1) very hard to do and (2) a rare event. As context, there are roughly 5,000 seed stage startups a year and only 800 of them raised a Series A round in 2016 reported Mattermark. Why do so many startups fail to successfully raise an A round? There are many reasons for this but most often it is because there is insufficient confidence among investors that the business has found or will find core product value or product/market fit. Andy Johns points out that among the right questions to ask when thinking about whether something has core product value are: Is the problem your product is solving (1) painful, (2) important for your customers, and (3) is there a sizable market behind this problem?  He adds that: “some firms create new, meaningful experiences, rather than solving an existing, painful problem. One could count Facebook, Twitter, Snapchat, Instagram, and others in this group.”

Fred Wilson describes the steps on a startup’s journey:

“The first step you need to climb is building a product, getting it into the market, and finding product market fit. I think that’s what seed financing should be used for.

The second step you need to climb is to hire a small team that can help you operate and grow the business you have now birthed by virtue of finding product market fit. That is what Series A money is for.

The third step you need to climb is to scale that team and ramp revenues and take the market. That is what Series B money is for.

The fourth step you need to climb is to get to profitability so that your cash flow after all expenses can sustain and grow the business. That is what Series C is for.

The fifth step is generating liquidity for you, your team, and your investors. That is what the IPO or the Secondary is for.”

Fred seems to be saying that he wants his portfolio companies to have product/market fit before the Series A which means they will also have discovered core product value as part of that process. It is worth pointing out that what constitutes product/market fit is always to a degree in the eye of the beholder, is not a discrete event and can disappear (e.g., a competing product emerges) and reappear like a Cheshire cat. I did a quick survey of a few VCs to get a current sense of what the standards are on product/market fit at a Series A financing. One venture capitalist I talked to said that only 5% of Series A rounds involve a company that does not have product/market fit. Another said that the percentage ranged from 10 to 40% depending on the firm and that it varies by partner. He also said that Series A rounds that do not have product/market fit “tend to skew smaller ($3-5M) and the firm tends to lead taking the whole round.” Another VC mentioned that there has been some easy grading on whether product/market fit exists and so that impacted her estimate of 20%. Another VC said: “15-20% are non-PMF A rounds, but they seem to be exceptional either by virtue of all-star founding team or a particularly hot area.” Another VC joked that that 30% of A rounds funded by VCs did not have product/market fit intentionally and another 29% failed to achieve this unintentionally. Raising funds after the seed round without proven core product value and product/market fit or can happen for many reasons including because the venture backers: (1) confuse progress on the growth hypothesis with a solution to the value hypothesis (product/market fit); (2) hope that product/market fit can still be discovered with more cash or (3) various errors in judgment caused by a really great story told by a really great story teller. The startup landscape is littered with the invisible dead bodies of failed startups.

The VCs I talked to generally said that a Series A without product/market fit was more likely if there is a huge potential market, a great story is being told and the specific venture capitalist involved is a “people person” on a relative basis.Having said that, Josh Kopelman’s advice on this issue is excellent: “Keeping your burn rate low until you have product/market fit will give you the best chance at building a big company. There’s nothing that increases your odds of a successful A round like a successful launch followed by customers that really love what you’ve built. These inflection points change year to year — so be sure you know what’s currently fundable.” Someone like Elon Musk may be able to raise an A round without core product value and product/market fit, but you are not Elon Musk, and neither am I.

As an aside, as Mark Suster and others have said:

“what actually IS the definition of a seed vs. A-round.

‘Cautionary note: No competent VC is actually fooled when you show up after raising $6M in seed financing and say you’re now raising an A!’

— Marc Andreessen (@pmarca) October 7, 2014

This is something I think entrepreneurs don’t totally understand and it’s worthwhile they do. My view: “Spending any time or energy trying to game the ‘definition’ of your round of fund raising is a total waste. Nobody cares. No VC will be so naive as not to see straight through it. And actually many will probably find the gamesmanship as a bad sign of lack of property priorities or perspective.”… If it looks like an A-round, smells like an A-round & tastes like an A-round … it’s an A-round…. if you raised $3–5 million from well-known seed funds or from a VC and you’re asking for $8–10 million in your next round … that next round is a B-round no matter what we collectively decide to call it when we VCs fund you.”

It is possible for a startup which has not proven that they have core product value and product/market fit raise a Series B? Sure. But is it likely? No. is is significantly less likely that in an A round.  Significantly fewer firms raise a Series B than a Series A. Sreies B is often called the hardest round to raise. Fred Destin writes: “Series B is hard for a simple reason: suspension of disbelief fades and is replaced by an increasingly cold, hard look at milestones and progress. Series B is the round where the rubber meets the road, where the promise has to be met with numbers and projections.”


Andy Chen has written about TTPMF – the “Time to Product/Market Fit.” Remembering that you must have core product value to get to product/market fit his view is:

“TTPMF has to be less than 1-2 years or else your startup will implode. Ask anyone who’s been working on a product for more than 2 years and doesn’t have traction to show: It really, really sucks. The first 6 months can be fun because it feels like you’re painting on a blank canvas, but soon enough, there’s just fatigue and the window of opportunity shifts. Platforms change, investors get disengaged, your employees start getting excited about other companies. So if you miss your window, then you’ll run out of money or energy or both.”

Chamath Palihapitiya has a gift for getting to the point.  You can’t make the most important point about core product value in a simpler way than this slide:



Steve Blank believes: “The best entrepreneurs are the ones who are passionate about solving a problem because they’ve had it or seen others have it, love those customers, love solving that problem or have been domain experts. Those are authentic entrepreneurs.” He believes “entrepreneurs, at their heart, are artists. … What comes out from the great artists is something completely unexpected. World class entrepreneurs understand something that is driven by passion.” He believes world class entrepreneurs are connected to their subject and with their customers.’ Blank believes entrepreneurship is a calling rather than a job.  I believe that this is why many venture capitalists describe what they do as “artisanal.” Blank believes:

“Founders fit the definition of a composer: they see something no one else does. And to help them create it from nothing, they surround themselves with world-class performers. This concept of creating something that few others see – and the reality distortion field necessary to recruit the team to build it – is at the heart of what startup founders do. It is a very different skill than science, engineering, or management. Entrepreneurial employees are the talented performers who hear the siren song of a founder’s vision. Joining a startup while it is still searching for a business model, they too see the promise of what can be and join the founder to bring the vision to life.”

The great entrepreneurs tend to be persistent, obsessive and relentless, but the really great entrepreneurs also seem to have a gift for looking at the world from a customer’s viewpoint. These entrepreneurs seem to know instinctively what the customer wants. Most artistic entrepreneur I have ever seen is Craig McCaw. He has an amazing way of putting himself in the shoes of the customer. Rich Barton is very similar in his ability to know whether (1) the customer’s problem is real and significant enough that they will pay for the solution, the market is big, and that there is a business model with a potential moat. Steve Jobs had an artist’s skills in understanding what customers wanted. Bill Gates, Jim Sinegal and Howard Schultz all fall in the artist category. The people are also missionaries rather than mercenaries.  Missionaries are far less inclined to sell the business and more inclined to build a franchise that is truly lasting. Do all founders who are missionaries, visionary, persistent, obsessive and relentless succeed?  No. But they succeed more often. I talk about this is my blog post on the wonderful Michael Mauboussin book The Success Equation. Mauboussin wrote: “The trouble is that the performance of a company always depends on both skill and luck, which means that a given strategy will succeed only part of the time. So attributing success to any strategy may be wrong simply because you’re sampling only the winners. The more important question is: How many of the companies that tried that strategy actually succeeded?” Once up a time long ago I read a book called In Search of Excellence. The authors analyzed leading companies are sorted out the secrets of success in a way that suggested that it was a formula that could be replicated easily. The best companies do X, Y and Z was the claim. What was missing of course were all the companies that did X, Y and Z and failed. Mauboussin writes:

“There are numerous books that purport to guide management toward success. Most of the research in these books follows a common method: find successful businesses, identify the common practices of those businesses, and recommend that the manager imitate them. Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of companies and selected 11 that experienced an improvement from good to great results. He then identified the common attributes that he believed caused those companies to improve and recommended that other companies embrace those attributes. Among the traits were leadership, people, focus, and discipline. While Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because performance always depends on both skill and luck, a given strategy will succeed only part of the time.Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of business success fail to answer a critical question: How many of the companies that adopted a particular strategy actually succeeded?”

The best venture capitalists want to be involved in enabling entrepreneurs to be successful in this artistic process. You will sometimes hear people say “providing venture capital is just finance. You go to school and listen to a bunch of case studies and learn the formula.” That’s bullshit. I don’t know anyone with any significant degree of success in venture capital who thinks that way. The more the venture capitalist understands that finding core product value is an art and what they do is provide a service that goes beyond finance, the better their financial result.  The best venture capitalists spend a lot of time listening, let the founders do the heavy lifting and do not try to supply the vision (“You do not want a venture capitalist who hires a dog and then tries to do the barking”). Marc Andreessen says: “You want to have as much ‘prepared mind’ as you possibly can. And learn as much as you can about as many things, as much as you can. You want to enter as close as you can to a zen-like blank slate of perfect humility at the beginning of the meeting saying ‘teach me’…. We try really hard to be educated by the best entrepreneurs.”

Some of the best venture capitalists are people who ask great questions that help the entrepreneur find core product value and get to product market fit. Bruce Dunlevie is a great example of someone who has a service mentality in his work as a venture capitalist. Many entrepreneurs trust him implicitly since they know he asks great questions and has sound judgement. Here’s a story told by Jeff Hawkins about that skill:

“Hawkins: Yes, Palm was struggling. We had 27 employees, we had a couple of million dollars left in the bank. All of our partners had abandoned us on doing Zoomer 2. No one was interested in doing PDAs at all, and there was no real business selling PalmConnect and Graffiti. We were kind of bummed out, everyone was sort of miserable about it. But I still believed in the mobile computing space. So Donna Dubinsky and I went and visited one of our VCs one time, Bruce Dunlevie. We were sitting in his office and we were complaining about how our partners had abandoned us and how everything was hard, and Bruce said– my recollection was in an annoying tone, “Well, I don’t want to hear you complain about this. Do you know what you should be doing?” Something along those lines. And I said, “Yes, I know what we should be doing,” although I had no idea what we should be doing. But I said, “I can think of it”– immediately I said I can think of what we should do. If you ask me, I’ll tell you what we should do, something different. It occurred to me right away. I said, “Well we should do a new computer and we’re going to take everything we’ve learned and fix all the problems and do it again. That’s what we should do.” I didn’t know what that would look like yet because we had never really considered doing the whole computer again ourselves. We were still trying to work with Casio and GeoWorks and other people. And Bruce said, “Well if you know what to do, why don’t you go do it?” And our answer was, “We don’t really have the money to do that, we don’t really have the right type of people to do that– we only have software people. But if you think we can, if you don’t mind us trying, we’ll go do it.” And that was the beginning, the genesis of the Pilot. That night I went home and– I’m not sure, I think it was that night, maybe it was the next night, I don’t remember, I think it was that night.”

Here is an example of what WeWork’s Adam Neumann says about Dunlevie’s contribution:

“One example of this is Benchmark Capital, one of our investors. It’s a very successful VC firm, that works with companies like Uber, Snapchat, and Instagram. The partner that brought me in, Bruce Dunlevie, one of the original founders, is one of the smartest people I’ve ever met. Immediately after I met him, he became one of my five to seven close “advisors” that I asked a lot of both business and personal questions.”

There are many other successful entrepreneurs who tell the same story about Bruce. Someone I know said once: “Most stories about Bruce revolve around him being the world’ greatest person who is the best advisor anyone could ever hope for.” Those are qualities that an entrepreneur should seek in a venture capitalist. Dunlevie said to me once: “pattern recognition is an essential skill in venture capital.” While the elements of success in the venture business do not repeat themselves precisely, they often rhyme. In evaluating companies, the successful venture capitalist will often see something that reminds them of patterns they have seen before. It might be the style, chemistry or composition of the team or the nature of the business plan. Some things will be fundamentally different but other things may be familiar. While the pattern will be similar, something in what the team is doing will seem to break a rule. Part of the pattern that is being recognized is a rule breaking innovation of some kind which drives new value.

Creating “core product value” by finding a value hypothesis that is capable of being the foundation of a valuable business is a process similar to alchemy says Benchmark Capital’s Peter Fenton:

“Doing this job for almost 20 years now has taught me far more about people than about business. So let me first answer what I’ve learned about business, and in this case I mean the business of investing in startups. I started out as someone who had all the conceptual overhead needed to sound intelligent in our world, Porter’s 5 Forces, the Innovators Dilemma, and Crossing the Chasm. I would, in my former firm’s parlance, develop a “prepared mind” in a sector so I could see where the logical opportunities should exist. I became an expert on Storage, on Application Software, on Supply Chain. All of that, I came to realize, was useless without the alchemy of an entrepreneur who was playing around with explosive market forces. Yes we can look, and it helps to look with a lens, but the best ideas and companies aren’t filling logical white spaces. They are touching nuclear reactor of some force that will yield, and yield quickly, to an entrepreneurial leader.”

“I also came to realize that at the beginning, no analysis can capture ‘what can go right’ without sounding like you are clinically insane. Having seen the Series A pitch for Facebook, Uber, Snap, Twitter, Vmware…$1B in revenue for any of those companies would have been nearly impossible to imagine. Yet in each of those cases, I vividly remember the meetings, the day, the setting…and this feeling that an exceptional entrepreneur had touched on something nobody else had understood at their level of depth and insight. Each in its own way felt limitless. I’ll never forget meeting Evan Spiegel in 2012 at Sightglass in SF and leaving thinking, I know with all of my being that this person, this product, will give humanity back the playful joy of self-expression, which had been stolen away by then current social networks. Sometimes it’s obvious.”

What else helps someone find core product value? Domain expertise, beginner’s mind, and a personal desire to solve a problem that has caused the entrepreneur genuine personal pain. Jim Goetz of Sequoia believes:

“Many of the entrepreneurs that we back are attacking a personal pain.” “The common thread [between Sandy Lerner and Len Bosack (the founders of Cisco), Reid Hoffman (LinkedIn) and Omar Hamoui (AdMob)] is that these were all sketchy misfits, unknowns, who all focused on [solving] personal pain points and were all willing to put something out early and iterate.”

The best case happens for the venture capitalist when someone has the savant qualities I described when it comes to products and is attacking a personal pain that the care about is a missionary fashion. Michael Moritz of Sequoia not surprisingly has the same views as Goetz: “When we help organize one of these companies at the beginning, it never looks like the world’s greatest idea. I think it’s the marketing and PR department that rewrites history and tells you that it was always the world’s greatest idea. What they don’t say is that at the very beginning there was great uncertainty and a great lack of clarity.” “We just love people who perhaps to others look unbackable. That has always been our leitmotif of doing business.” “If you have been around the start of success it is far easier to recognize it again.”

Steve Blank said this during a GigaOm video interview: “I did this at SXSW. I said ‘There are 500 people in this room. The good news is, in ten years, there’s two of you who are going to make $100 million. The rest of you, you might as well have been working at Wal-Mart for how much you’re going to make.’ And everybody laughs. And I said, ‘No, no, that’s not the joke. The joke is all of you are looking at the other guys feeling sorry for those poor son-of-a-bitches.’” Financial success in creating and funding startups follows a power law.  This means that a very small number of startup founders, employees and investors will reap most all of the financial rewards.  The overconfidence heuristic will make most everyone overconfident that the winners will include them. The inevitable failures are hard for individuals, but the right thing for society as a whole.

One thing is clear: if an entrepreneur wants to discover core product value they should find a venture capitalist who knows that journey well, has a service mentality, asks great questions and has sound judgment.


Chamath Slide Deck:

Fenton in Quora:

Andy Johns:

Index Ventures:

Alex Schultz:

Bruce Dunlevie story re Palm:

Bruce Dunlevie interview:

Fred Wilson:

Steve Blank: and

Andy Chen:

Adam Neumann:

Mark Suster:

Josh Kopelman:

A Dozen Ways “Virality” Can be Misused and Misunderstood


1. “The most important thing that we did [at Facebook’s] was I teased out virality and said you cannot do it. Don’t talk about it. Don’t touch it. I don’t want you to give me any product plans that revolve around this idea of virality. I don’t want to hear it.”  Chamath Palihapitiya.

I have the same concerns Chamath is talking about in writing more about virality than I did in my previous post on product/market fit. If Lord Voldemort is He Who Must Not Be Named then virality is perhaps the Business Concept That Must Not Be Named. But since you will hear the term virality so often I have concluded that it is worthwhile to discuss the concept further.  The term virality and ideas that underlie it are borrowed from epidemiology. There is math involved, but if I dig too far into that math now you may stop reading. The best summary description I have found for the non-math inclined was written by Watts, Peretti and Frumin:


2. “A viral product is one whose rate of adoption increases with adoption. Within a certain limit, the product grows faster as more users adopt it.” Sangeet Paul Choudary.

that word

If a business’s product is able to grow organically by means of direct customer-to-customer interaction it is viral. For example, Twitter and Instagram both have viral attributes. Twitter has encountered greater limits on its customer growth as it reached very large numbers of users and that has been disappointing to shareholders. Every business has an upper limit on growth and it is just a question of where and where they appear. The point where growth plateaus for any business is determined in no small part by the size of the addressable market. Andrew Chen has written a post in which he describes a business that has saturated its market as having” jumped the shark” which I think is apt. If a company like Twitter reaches a point where customer growth plateaus it has several logical choices. It can: (1) try to increase revenue per customer; and/or (2) try to create and grow profitable complementary services that serve new addressable markets.

3. “If you don’t delight a customer you don’t create a viral effect because delight is the greatest form of virality.” Andy Rachleff.

If you love a product you are going to tell your friends. If someone tells you about a product and it is not lovable you will stop using it. This simple idea reminds me of a well-known Warren Buffett quotation: The only way to get love is to be lovable. It’s very irritating if you have a lot of money. You’d like to think you could write a check: ‘I’ll buy a million dollars’ worth of love.’ But it doesn’t work that way.” Rachleff believes that a focus om growth before the value hypothesis has been solved is dangerous to the financial health of a business.

Rachleff points to Netflix as an example of a company that is totally focused on delighting its customers instead of being paranoid about competitors. Here Netflix is parting ways with the Andy Grove dictum about being paranoid about competitors and instead being focused on delighting customers. He quotes Reed Hasting’s as saying: “being paranoid about competition is the last thing you want to do because it distracts you from the primary job at hand: Delighting the customer.” Especially in a technology business where one company can dominate a market due to network effects, losing focus on delighting customers can be a fatal mistake. Steve Blank puts it this way: “Why are so many founders so reluctant to invest even 500 or 1,000 hours upfront to be sure that, when they’re done, the business they’re building will face genuine, substantial demand or enthusiasm?  Without passionate customers, even the most passionate entrepreneur will flounder at best.” 

Charlie Munger tells the story of young people approaching him and asking how they can become as rich as he is, but much faster. This desire to get rich quick or create a successful company quick can cause people to make serious mistakes. This most often happens because people seek shortcuts like trying to work the growth and value hypothesis at the same time. If it were easy and fast to do solve the value hypothesis by creating core product value protected by a moat everyone would be rich. The reality is that is no substitute for solving the value hypothesis first. People tell their friend about businesses like Netflix and Costco because the product is delightful. Bill Gurley writes: “’Wow’ moments lead to word-of-mouth viral growth and high net promoter scores.” That is the best type of virality a business can have.

4. “Products that exhibit viral growth depend on person-to-person transmission as a necessary consequence of normal product use. Growth happens automatically as a side effect of customers using the product.” Eric Ries.

Growth should ideally be driven by a natural byproduct of customers generating core product value from their use of the product. The less optional the sharing activity the more naturally viral the product is. Customer should derive value from sharing the product with others without the process feeling forced. Three slides from a presentation by Anu Hariharan of A16z helps clarify different types of viral growth and what the objective of viral growth should be:





The need to generate positive word of mouth is greatest when the business is offering a consumer product which has low average revenue per account (ARPA) relative to what it would be for an enterprise product. This chart from a lecture by Christoph Janz nicely describes a continuum. The lower the revenue per account (mice and insects)the less the customer acquisition cost (CAC) can be and still create lifetime customer value.  


Unfortunately the pressure to keep CAC low can create tremendous pressure to use clever tricks and hacks that may get in the way of delighting a customer. Spam is spam, even if it comes from someone who calls them self a growth hacker.

5. “Virality is something that has to be engineered from the beginning…and it’s harder to create virality than it is to create a good product.  That’s why we often see good products with poor virality, and poor products with good virality. Josh Kopelman. 

Building enough delight in to a product from the start is an essential element of virality. The goal is to make the customer say “WOW” when time they use the product. Roelof Botha agrees with Kopelman: “Forget about adding ‘viral’ to your marketing to-do list after your product is already on the market. You need to bake it into your business model from the very beginning. Viral isn’t something you can just make happen. It has to be inherent in your product.” Andy Rachleff writes:

“Facebook cut its teeth in the Ivy League without spending a nickel on marketing (or growth as they call it) before making its product more broadly available. Once the company had incredible traction, it broadened its reach. The same can be said for just about every franchise technology company we know (for example: Adobe, Apple, Google, LinkedIn, Oracle, Salesforce, and Twitter). The classic counter-example is Groupon. It ramped up the hiring of salespeople well in advance of determining if it offered customers (merchants) a compelling value proposition… post IPO, the market realized Groupon didn’t have a value hypothesis. In other words, Groupon was able to succeed for a while without a proven value hypothesis, but sooner or later the truth catches up with everyone.”

6. “Most viral acquisition is built around incentives. Users are incentivized either explicitly (with a clear dangling carrot) or implicitly (through product mechanics) to invite other users.” Sangeet Paul Choudary.

One approach is to offer existing customers an additional amount of a free service for every successful customer referral. Choudary has created a taxonomy of incentives that includes categories like Network Value, Single-Player Value, Interaction Value, Immediate Value and Mutual Value. For example, in the Network Value category he cites “Draw Something where users may invite friends because they get interesting opponents in the longer run.” He adds: “Of course, platforms may use a combination of the above strategies. Dropbox uses a combination of Network Value, Single-Player Value and Mutual Value to incentivize users. Groupon uses a combination of Immediate Value, Interaction Value and, to some extent, Mutual Value.” Choudary has a great post on his blog about how natural incentives can be created:  “Today’s social startups don’t start off as networks. They start off as standalone apps. These products enable users to create a corpus of content first. They then connect the users with each other as a consequence of sharing that content.”

7. “The goal of all viral efforts is to insert (or “incept”) an idea of what a product can do into someone else’s head, and to get them so excited about it they want to try it and use it. Remember, at the end of the day, there’s only one metric that really matters. How many people are actually using your product.” Josh Elman.

In terms of the right approach and additional metrics, Adam Nash suggested this approach in a slide deck:


8. “Without first creating approximate viral memes that are (a) logically consistent a site’s primary value proposition and (b) resonate with something fundamental in the audience’s psyche, its virtually impossible to jumpstart a viral growth cycle.”  Ravi Mhatre.

Delighting customers with magic moments are critical to creating sustainable viral growth. These magic moments are sometimes referred to as “A-Ha moments.” Whatever they are called the objective of the business is to create an emotional affinity with the product for its customers. Delight and love are strong words but they are the right words. Chamath Palihapitiya describes the objective simply:How to get them to an “A-ha” moment as quickly as possible? And then how do you deliver core product value as often as possible?” Instagram, Snapchat and WhatsApp are businesses were successful in creating magic moments and therefore viral growth. Hotmail is often used as an example to illustrate viral growth. Sabeer Bhatia and Jack Smith developed a system that displayed an email displayed on a web page. People tend to forget how much delight that product created with customers. An email on a web page that could be accessed from anywhere for free was magical at that time. In terms of a built in mechanic that enabled virality on top of the underlying customer delight each Hotmail message had the words: “Get your free email at Hotmail” at the bottom. Clicking on those words took the person to the Hotmail signup page that explained that the service was free and accessible from any computer. Hotmail was able to acquire more than 12 million subscribers in 18 months despite spending less than $500,000 on marketing. Just the clickable mechanic without the customer delight would not have worked for HotMail.  

9. “No single feature determines the virality of the product – instead, it’s part of a viral loop that connects a disparate set of functions into a cohesive motivation for the user to tell their friends.” Andrew Chen.

If the business can reinforce the magic moments in a feedback loop that continuously reinforce core product value that generate not only growth but a moat against competition. If data is collected during that process the moat gets even stronger. Adora Cheung pointed out in a Stanford Class called How to Start a Startup: “there are three types of growth. Sticky, viral, and paid growth. Sticky growth is trying to get your existing users to come back and pay you more or use you more. Viral growth is when people talk about you. So you use a product, you really like it and you tell ten other friends, and they like it. That’s viral growth. And the third is paid growth.”  It’s hard to overemphasize the value of retaining customers (stickiness) in generating lifetime customer value. As I pointed out in my post on growth, the best way to grow is not to shrink. This may seem like a paradox but it is clear when you do the customer lifetime value math.

10. “My biggest fear was we spam our users and we trick them and it will alienate these people. You won’t see it today but you’ll see in three years from now or four years from now, and it accelerates when you compound that with a competitor who actually builds a better product that doesn’t alienate people.” Chamath Palihapitiya.

Using tricks to generate invitations when there is no core product value is suicidal. Virality without product market fit means what will be communicated virally is that the product sucks. Alex Schultz describes a healthy process where the business actually builds a better product as follows:

“with virality, you get someone to contact import that site. Then the question is, how many of those people do you get to send imports? Then, to how many people? Then, how many click? How many sign up? And then how many of those import. So essentially you want people to sign up to your site to import their contacts. You want to then get them to send an invite to all of those contacts – ideally all of those contacts, not just some of them. Then you want a percentage of those to click and sign up. If you multiply all the percentages/numbers in every point in between the steps, this is essentially how you get to the point of ‘What is the K factor?’ For example, let’s says 100 people get an invite per person who imports, then of those, 10% click, and 50% sign up, and of those only 10 to 20% import, you’re going to be at 0.5 – 1.0 K factor, and you’re not going to be viral. A lot of things like Viddy were very good at pumping up stories. They got the factor over 1, which is perfectly doable. But if you’ve got something that doesn’t have high retention on the backend, it doesn’t really matter. You should look at your invite flow and say ‘okay, what is my equivalent to import, how many people per import are invites sent to, how many of those receive clicks, how many of those convert to my site, how many of those then import,’ in order to get an idea of you K factor. The real important thing is still to think about retention, not so much virality, and only do this after you have a large number of people retained on your product per person who signs up.”

11. “The most disappointing answer is when [entrepreneurs] say ‘Oh, we’ll just make it viral.’  As if virality is something you can choose to add in after the product is baked – like a spell checker. The reason that over $150 Billion is spent on US advertising each year is because virality is so hard.  If virality was easy, there would be no advertising industry.” Josh Kopelman. 

The cost of acquiring a customer is never zero especially after you consider cost of goods sold (COGS) that is often hidden CAC (e.g., freemium). There is nothing in a viral marketing approach that is inconsistent with mass media advertising, including spending on marketing to create a seed of customers that has viral attributes. Marc Andreessen agrees with Kopelman: “Many entrepreneurs who build great products simply don’t have a good distribution strategy. Even worse is when they insist that they don’t need one, or call no distribution strategy a ‘viral marketing strategy. Andreessen Horowitz is a sucker for people who have sales and marketing figured out.”’ As an example, Blake Masters writes about a lecture Peter Thiel gave that discusses virality and seeding a market as follows:

“The PayPal team reached an important conclusion: Business development didn’t work. They needed organic, viral growth. They needed to give people money.  So that’s what they did. New customers got $10 for signing up, and existing ones got $10 for referrals. Growth went exponential, and PayPal wound up paying $20 for each new customer. It felt like things were working and not working at the same time; 7 to 10% daily growth and 100 million users was good. No revenues and an exponentially growing cost structure were not. Things felt a little unstable. PayPal needed buzz so it could raise more capital and continue on. (Ultimately, this worked out. That does not mean it’s the best way to run a company. Indeed, it probably isn’t.).”

12. “There are many products that exhibit virality without exhibiting network effects. A case in point being email and cross-platform communication products. There are many others that exhibit network effects without exhibiting virality. Products with indirect network effects such as marketplaces may not grow virally.” Sangeet Paul Choudary.

I have already written a post about network effects but this is the first time I have written specifically about virality. The two terms are often confused since they can occur at the same time. Network effects exist when a product gets more valuable the more people use it. Network effects are about increasing value and drive business success by increasing the size of a business’s moat. Virality is about increasing speed of adoption and lowering customer acquisition cost (CAC). As an example, the game Angry Birds was viral, but it did not have network effects. Many multi-sided marketplaces have network effects, but are not really very viral. Facebook is viral and has network effects. Andy Rachleff provides the best closing quote for this post by reinforcing a key idea this post has tried to drive home: “Network effects often drive virality. But another thing that drives virality is delight.” When I took driver education classes years ago the teacher would say that if you found yourself headed for a telephone pole look where you want the car to go not at the pole or else you wold steer into the pole.  Similarly a startup should look at delighting its customers with magic moments and avoid the pole which is an early focus on the growth hypothesis.


Rachleff Twenty Minute VC podcast:

Rachleff Essay in Fast Company:

Rachleff on First Round Review: 

Watts, Peretti and Frum:

Anu Hariharan A16Z Slide Deck

Bill Gurley:

Sangeet Paul Choudary:


David Skok: 


Andrew Chen:

Virality vs Network Effects

How to Start a Startup:

Chamath Palihapitiya

Incentives: How to Engineer User Growth and Virality

The Five Types of Virality

Steve Blank:

Seven Ways to go Viral:

How to measure the product virality

Why Trello Failed to Build a $1 Billion+ Business:

From 0 to $1B – Slack’s Founder Shares Their Epic Launch Strategy





You have Discovered Product/Market Fit. What about a Moat?

I have previously written blog posts about (1) growth, (2) product/market fit and (3) minimum viable product. The most logical topic for the next post is: Why does a business need a moat? The answer is simple: even if a business discovers solutions to the value hypothesis and the growth hypotheses without a moat the probability of the business being financially successful over time is remote. Revenue alone is not enough to sustain a business given the inevitable competitive response. A sustained return on invested capital is a prerequisite for the long-term survival of a business. In other words, “for what shall it profit a business, if it shall discover solutions to the value a growth hypotheses, but fail anyway because it does not have a moat?” At worst, the business without a moat is never profitable (like At best, the business without a moat is profitable for a while, but over time is gradually overtaken (as may be happening right now to GoPro).

Questions about the creation, maintenance and destruction of moats are the most fascinating and challenging aspects of business and investing. This is true because what Joseph Schumpeter called “creative destruction” is more powerful than any phenomenon in business. Michael Mauboussin says it best: “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive return, which will drive aggregate industry returns to opportunity cost of capital.”

The moat creation and destruction process is similar to what happens during evolution in nature. What’s an example of a specific moat analogy from nature? The sword-billed hummingbird is a species from South America. The bird’s very long sword-like bill acts as a moat against competitors by allowing it to reach a unique source of nectar from long-tubed passion flowers.


Why did I select this hummingbird to illustrate my point? First I wanted to leverage the fact that you may have recently watched one notable episode the BBC’s Planet Earth series. Second, while the humming bird has a moat due to its long beak, the bird’s market is limited to a small number of flowers in a relatively small territory. Some moats are operative in small markets and some are big. Twitter’s moat may only protect something that generates $600 million a quarter in revenue, which some people might consider to be relatively small like the hummingbird’s territory. Or Twitter’s revenue may grow much larger. Therein lies much of the fun and challenge in investing. As an aside, since I know you want to know, hummingbirds do tweet.

Mistakes are easy to make when trying to make predictions about moat strength, value and duration. For example, even if a business currently has a moat, that does not mean it will continue to do so for very long. Some businesses were at one point very highly valued since investors mistakenly thought they had a strong moat in a large and valuable market. GoPro would seem to be an example:


Predicting the future of a moat is so hard because the markets in which they operate are complex and adaptive. I wrote about why it is hard to predict the future in this post. Factors that can create a moat are constantly in flux and because they often interrelate to create nonlinear positive and negative changes. An example of negative outcomes for a business from a shift in the strength of a moat is what happened to the newspaper industry when publishers lost their physical distribution-based moat.

Without a moat this can happen:

“There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” Charlie Munger

The point Munger just made so clearly is counter-intuitive for many people, but essential to understand. Moat creation is incredibly hard and rare and maintaining one is hard as well. It is a big mistake to confuse a moat shortage with an innovation shortage. Some innovation does not produce any profit and in fact can destroy profit. For every firm creating disruption, some other firms are being disrupted.

The test of whether a moat exists is quantitative, even though the factors that create moats are qualitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for three to five years, it does not have a moat.  That is quantitative. As for the qualitative side of this topic, there are no formulas or recipes that govern the creation and sustainability of moats, but there is enough commonality that you can get better at understanding how they are created and whether they can be maintained over time. Charlie Munger told Howard Marks once: “It’s not supposed to be easy. Anyone who finds it easy is stupid. There are many layers to this and you just have to think well.” The existence and need to understand the many layers Munger is talking about explains why there are so many different posts on this blog. And why Warren Buffett believes that business is the most interesting game ever invented. The need to “learn more about more” never ends. Ever. What are these “layers” that Munger is talking about?  Marc Andreessen puts it this way:

“I have always been a fan of something that Andy Rachleff taught me years ago, which he calls the onion theory of risk. Which basically is, you can think about a startup like on day one, as having every conceivable kind of risk and you can basically make a list of the risks. So you’ve got founding team risks, are the founders going to be able to work together; then you have product risk, can you build the product; you will have technical risk, maybe you need a machine learning breakthrough or something. Are you going to have something to make it work, or are you going to be able to do that? You will have launch risk, will the launch go well; you will have market acceptance risk, you will have revenue risk. A big risk you get into with a lot of businesses that have a sales force, is that can you actually sell the product for enough money to actually pay for the cost of sales? So you have cost of sales risk. If you are a consumer product, you have viral growth risk. So a startup at the very beginning is just this long list of risks, right, and the way I always think about running a startup is also how I think about raising money. Which is a process of peeling away layers of risk as you go.”

Among the risks Andreessen talks about are technology, product, market, competition, timing, financing, distribution, marketing, hiring and founder. Each must be retired at some point by the business. The existence of a moat is critical to reducing competition risk. In my blog post on Eugene Kleiner I quote him as saying“Risk up front, out early.” A famous venture capitalist said to me that Kleiner: “Always had a strong bias for eliminating the biggest risks quickly, which was much more relevant in the days of backing companies with high technical risk and low market risk.” Another famous VC who knew Kleiner well wrote to me that what he meant by this sentence was: “Reduce the biggest risks first for the fewest dollars. This may mean out of order execution to minimize loss in case of failure.”

I view the great moat creators of the world as artists. When someone like Rich Barton creates or is involved in the creation of successful business after successful business (Expedia, Zillow, Glassdoor, Avvo, Realself, Nextdoor) when the failure rate for startups is as high as it is, I can’t help but be impressed. Bill Gates created several moats for different product as did Steve Jobs. When someone does something repeatedly you can be assured that the skill to luck ratio weighted strongly toward skill.  One point is clear from the numbers (AKA, empirical evidence): moat creation in a really large and valuable market is rare event. This must be the case since the number of financial exits is top-down constrained by the size of the economy and its ability to absorb profitable new businesses. Venture-backed businesses overwhelmingly fail financially as I wrote in my post last week on minimum viable products.

The major factors that can create a moat are:

  1. Demand-side Economies of Scale

Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it. Microsoft, Amazon, Google, Facebook and other multi-sided markets have demand-side economies of scale that operate on their behalf. Network effects represent the most valuable factors creating a moat since the benefits of demand-side economies of scale can increase in business value a nonlinear manner, especially in software businesses. Moats created by network effects are vastly more scalable than other types of moats. This means that the benefits realized by the major software-based platforms are far larger than those realized by a large steel or cement producer based on supply-side economies of scale. Network effects are extremely hard to create and, as Blackberry found, can be very brittle.  Of all the factors that can create a moat, nothing is more important than network effects in my view. A great example of the value of network effects are Bloomberg terminals. The more people who use these terminals the more valuable they become to other users. The FT writes:

“Bloomberg’s pioneering instant messaging and chat rooms, not data or news, are arguably one of the biggest drivers of its dominance. The bond market — where trading mostly happens discreetly between fund managers, brokers and banks, rather than on bourses — is particularly dependent on the Instant Bloomberg messaging function. But “I’ll IB you” has become lingua franca across the financial world. The dominance of Bloomberg chat is a significant “economic moat” for the company.”

  1. Supply-side Economies of Scale

A business generates supply-side economies if per-unit costs fall with increasing output. Economies of scale, with a few rare exceptions, are exhausted well before businesses dominate the entire market.” For example, despite having significant supply-side economies of scale, General Motors never was able to obtain 100% market share. Costco has supply side scale economies of scale that help create its moat, but it is not even the only warehouse club in terms of market share. Costco is nevertheless a hugely valuable business that is Charlie Munger’s favorite business after Berkshire Hathaway. Both Amazon AWS and Microsoft Azure have supply-side economies of scale that benefit their business.

  1. Brand, Patents and Intellectual Property

Charlie Munger and Warren Buffett discovered soon after they bought See’s Candies that they could regularly raise prices and customers did not seem to care. Buffett and Munger call this ability “pricing power.” Charlie Munger has pointed out that before See’s Candies: “We didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning this changed Berkshire. It was really important.” People do conduct surveys and try to rank brands which is in my view is the equivalent of guessing.


A patent or other form of intellectual property like trademarks or copyrights can create a moat. Qualcomm is an example of a company that has created a moat mostly via intellectual property. Open source makes moats on some areas of the software business problematic. Proprietary software kept secret in a server does not need to have the same intellectual property protection as client side software.

  1. Regulation:

There are certain businesses which have created a competence with regard to regulation that is so high that regulation serves as a moat. As an example, lawyers and other professional are able to reduce supply and create a moat through regulation. As an example, having the regulatory expertise to qualify to do business as a web services provider on a global basis on behalf of customers is a form of moat.

Can great management or better business execution create a moat? Warren Buffett’s famous quip on that point is: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Professor Michael Porter agrees: “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.” Competition will in that case eventually be based on price and price-based competition inevitably degrades to a point where profit disappears. This is not to say that great management is not highly valuable. It is. But people like Buffett and Porter believe it isn’t enough to reliably sustain profitability over long periods of time. Some companies which execute operationally have a great run of success but eventually fall victim to competition catching up with best practices.  Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”


Mauboussin- Measuring the Moat

A Dozen Things I’ve Learned from Charlie Munger about Moats

Lecture 9 How to Raise Money

FT on the Bloomberg Terminal:

Eugene Kleiner

A Dozen Lessons about Minimum Viable Products

  1. “It’s only cheap to build 2-3 person companies with sweat equity. The minute you start paying engineers you will realize it is quite expensive.” Bill Gurley.  Assume a startup has raised a seed round of ~$2 million. Also assume that what the startup has is a hypothesis that a big market composed of dogs will want to eat the dog food described by the hypothesis. The founders of the startup have no proof that their hypothesis is true, but some investors have voted with their money that there is significant hope that the startup’s hypothesis is correct. Every penny of the $2 million raised by the startup is precious. If the startup runs out of cash it is dead, since that is the only unforgivable sin in business. Now let’s look at the overall context in which this is happening. The odds that the startup will be financially successful are, simply put, not good. How many startups raise a seed round? There is no way to know for sure since many startups at seed stage live and die and don’t leave a trace that can be tracked. Reported seed stage startups typically number about 1,200 in a given a quarter (plus or minus a couple of hundred) depending upon the business climate.  Assuming ~5,000 seed stage startups a year both reported and unreported, only 800 of them raised a Series A round in 2016 says Mattermark. That’s about an 84% fatality rate just at seed stage. Mattermark also calculates the odds of survival here at far less than 10%. This calculation is based simply on a startup not getting to the next phase.


Other research, which uses different definitions, concludes:

About 75% of U.S. venture-backed start-ups fail, according to Harvard Business School senior lecturer Shikhar Ghosh. Ghosh’s research estimates 30% to 40% of high potential start-ups end up liquidating all assets–a failure by any definition. But if a start-up failure is defined as not delivering the projected return on investment, then 95% of VC companies are failures, Ghosh said.

Being a founder or early employee of a startup is not a rational act given the odds of success. Of course, as George Bernard Shaw wrote in Man and Superman: “all progress depends on the unreasonable [human being].” The reason why books like The Hard Thing about Hard Things by Ben Horowitz and Shoe Dog by Phil Knight resonate so strongly with people who have been involved in startups is that they accurately describe the terror, inevitable setbacks and daily struggle of life in a startup business, not just the seemingly glamorous parts. .

  1. “If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.” Jessica Livingston. The first rule of startups is that without making something that people want to buy, you’re dead. The second rule is that you should not forget the first rule. Particularly when the odds of survival are low in an activity, it pays to be very aware of methods that can increase the probability of survival. Michael Mauboussin’s advice should be front and center in every founder’s mind: “If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions.” What should that process be for a startup? In thinking about the right process it is wise not to forget that the startup’s goal is to establish product/market fit before they run out of money. Unfortunately, at the very early stages of the startup’s existence it faces many challenges related to at least one untested hypothesis. “Hypothesis”, of course,  is just a fancy word for “guess.” Steve Anderson the founder of the seed stage venture capital firm  Baseline Ventures points out: “Generally speaking, most of my investments are pre-product launch – they’re just an idea. My goal as an investor is to make sure there’s enough financing to give companies time to do that, a year to 18 months. The worst scenario is to try to raise more money when you haven’t achieved that goal. If you don’t have it, eventually you’ll run out of cash, say the experiment is wrong, and fold up your tent. That’s why when I invest I want to leave enough room for pivoting or reexamining your goals.” Making matters even more challenging for the early stage startup is the point Ev Williams makes here: “You know that old saw about a plane flying from California to Hawaii being off course 99% of the time—but constantly correcting? The same is true of successful startups—except they may start out heading toward Alaska.”
  1. “A full executive team with a salesforce and all that stuff before you have a killer product is a complete waste of time.” Marc Andreessen.  A startup should defer spending time and energy proving and developing its growth hypothesis until it has established the value hypothesis. I have recently written a blog post on precisely this “first value THEN growth” point here. The key point in that post is made by Andy Rachleff: “A value hypothesis identifies the features you need to build, the audience that’s likely to care, and the business model required to entice a customer to buy your product. Companies often go through many iterations before they find product/market fit, if they ever do.” When the startup is still searching for the elements of its value hypothesis, money and time spent on growing the business is a bonfire of cash generating zero value. The early days of the life of a startup are focused on “search” rather than “execution” advises Steve Blank, a serial entrepreneur, professor and author who is justifiably famous in the startup world.
  1. “The minimum viable product (MVP) is that product which has just those features (and no more) that allows you to ship a product that resonates with early adopters; some of whom will pay you money or give you feedback.” “The lesson of the MVP is that any additional work beyond what was required to start learning is waste, no matter how important it might have seemed at the time.” Eric Ries. The goal of the MVP process is to validate the hypothesis in a speedy and cost efficient manner. The key word in this quote from Ries above is feedback since that is how anyone learns. The most effective processes are based on feedback loops which are in turn based on the scientific method: build, measure, learn. What the startup offers as its MVP should be compete in what it does to deliver and capture value, not a fully complete implementation of the vision. The MVP is an experiment that is intended to generate validated learning about what customers value enough to pay for. An MVP approach is not the only way to go forward with a startup. Eric Ries describes two extreme alternatives:

“One, which I call maximizing chance of success, says ‘Look, we only got one chance at this so let’s get it right.’ We’re going to ship it when it’s right and that actually is perfectly rational. If you only have one shot, you want to take the best shot you can and build the most perfect product you can. The issue is, of course, you know, you can spend, I don’t know, say five years of stealth R&D building a product you think customers want and then discover to your chagrin that they don’t. The other possible extreme approach is to say, ‘Well, let’s just do ‘release early, release often.’ This approach is: ‘Look, we’ll just throw whatever crap we have out there and then we’ll hear what customers say and we’ll do whatever they say.” But the issue there is if you show a product to three customers, you get 30 opinions, and now what do you do? So minimum viable product is kind of a synthesis of those two possible extremes.”

  1. “As you consider building your own minimum viable product, let this simple rule suffice: remove any feature, process, or effort that does not contribute directly to the learning you seek.” “If you want to do minimum viable product, you have to be prepared to iterate. And so you have to have the courage to say, ‘Yeah, we’ll ship something, get negative feedback and respond.’” Eric Ries.  A minimum feature set is not a goal but a tactic to create cost-effective and speedy validated learning about the hypothesis. The goal is to learn and steer based on feedback rather than try to predict and emerge with a killer fully formed product. Some people like Peter Thiel who is quoted just below, have a different view:

“Even in engineering-driven Silicon Valley, the buzzwords of the moment call for building a ‘lean startup’ that can ‘adapt’ and ‘evolve’ to an ever-changing environment. Would-be entrepreneurs are told that nothing can be known in advance: we’re supposed to listen to what customers say they want, make nothing more than a ‘minimum viable product,’ and iterate our way to success. But leanness is a methodology, not a goal. Making small changes to things that already exist might lead you to a local maximum, but it won’t help you find the global maximum. You could build the best version of an app that lets people order toilet paper from their iPhone. But iteration without a bold plan won’t take you from 0 to 1. A company is the strangest place of all for an indefinite optimist: why should you expect your own business to succeed without a plan to make it happen? Darwinism may be a fine theory in other contexts, but in startups, intelligent design works best.”

Thiel or an entrepreneur like Elon Musk are not as capital constrained as the typical seed stage startup. They can afford to adopt what Ries called a “maximizing the chance of success” approach. Thiel in particular makes many bets and is nicely hedged since he owns a portfolio of wagers. In contrast the founders and early employees of a startup typically have all their eggs on one basket. The founders and early employees are far from hedged. What is right for Thiel may not be right for founders or early employees for that reason.

  1. “An MVP is a process that you repeat over and over again: Identify your riskiest assumption, find the smallest possible experiment to test that assumption, and use the results of the experiment to course correct.” Yevgeniy Brikman. The MVP process is depicted as a flywheel or loop for a reason. Most of the time actual testing of a hypothesis will reveal that customers do not value the product or even the vision the product represents. If the hypothesis is not validated by the experiment the business must iterate by replacing the hypothesis or shut down. I like this description of the process from an interview of Steve Blank by Chris Dixon:

“An MVP is really just a tool for discovering a scalable business model through customer development. An MVP should have the smallest possible feature set that creates gains for customers and reduces pain—but it can’t be so small that customers have nothing to evaluate. In other words, an MVP gives startup entrepreneurs something to demonstrate when they get out of the building and talk to current and potential customers about what they really need.”

  1. “The worst fate of any shipping of any product is that nobody cares. You don’t get any feedback at all. That’s what most features or most products do. They’re just dead weight.” Eric Ries.  What Ries says here is an unfortunate fact. Chamath Palihapitiya describes reality bluntly: “Core product value is really illusive and most products don’t have any.” Faced with the reality of shutting down many companies just push the button and start working on the growth hypothesis without having solved the value hypothesis, starting a process in which they will usually fly the business at high speed into the side of a mountain.
  1. “The common phrase that most people use today is,”You should build a minimum viable product.” And I underlined viable because I think a lot of people skip that part and they go out with a feature and the whole user experience in the very beginning is flat. Minimal viable product pretty much means what is the smallest feature set that you should build to solve the problem that you are trying to solve. I think if you go through the whole story-boarding experience you can kind of figure that out very quickly. But again, you have to be talking to users, you have to be seeing what exists out there already, and what you should be building should solve their immediate needs.” Sam Altman. The graphics which best describe what Altman is talking about depict the MVP as being complete in terms of what it does but not as complete as it will eventually be in implementing the vision once the feedback is obtained from early adopter customers.



  1. “A minimum viable product is not always a smaller/cheaper version of your final product.” “Launching a new enterprise—whether it’s a tech start-up, a small business, or an initiative within a large corporation—has always been a hit-or-miss proposition. According to the decades-old formula, you write a business plan, pitch it to investors, assemble a team, introduce a product, and start selling as hard as you can. All MBA tools are irrelevant on a startup’s day one. This wrong belief is based on that we can start absolutely any company just by spending a lot of time on writing complicated operating plan and financial model and then hire people to execute this plans. But now we know that no plan survives first contact with customers! First days of startup are completely unpredictable. Business plans and financial forecasts are just silly as it was in the Soviet Union.” Steve Blank. A classic example of a MVP is what was done by Zappos Founder Nick Swinmurn: “My Dad told me, you know I think the one you should focus on is the shoe thing. That’s a real business that makes sense. So I said okay, focused on the shoe thing, went to a couple of stores, took some pictures of the shoes, made a website, put them up and told the shoe store, if I sell anything, I’ll come here and pay full price. They said okay, knock yourself out. So I did that, made a couple of sales.” If you can validate your thesis without paying to create lots of code that approach is like found gold. As another example, the MVP for AngelList mostly took the form of making introductions by email. The Virgin Airlines MVP was just a single plane flying back and forth between two cities. The less money spent on proving the hypothesis, the more money that is left to pivot or execute on the idea.
  1. A MVP is not just a product with half of the features chopped out, or a way to get the product out the door a little earlier. And it’s not something you build only once, and then consider the job done.” Yevgeniy Brikman. The MVP should deliver value to the customer even though it is not as complete at is could be. Some people argue that an MVP can be as simple as a landing page, but I am skeptical. Eric Ries writes: “The idea of minimum viable product is useful because you can basically say: our vision is to build a product that solves this core problem for customers and we think that for the people who are early adopters for this kind of solution, they will be the most forgiving. And they will fill in their minds the features that aren’t quite there if we give them the core, tent-pole features that point the direction of where we’re trying to go.”


  1. “MVP is quite annoying, because it imposes extra overhead. We have to manage to learn something from our first product iteration. In a lot of cases, this requires a lot of energy invested in talking to customers or metrics and analytics. Second, the definition’s use of the words maximum and minimum means it is decidedly not formulaic. It requires judgment to figure out, for any given context, what MVP makes sense.” Eric Ries. It does not make much sense to build a MVP unless you do the work to collect data about the experiments and conduct an analysis using modern tools. This data collection and analysis is a lot of work and is not as glamorous to some people as product design, creating marketing plans and attending fancy conferences and parties.
  1. “In the real world not every customer is going to get overly excited about your minimum feature set. Only a special subset of customers will and what gets them breathing heavy is the long-term vision for your product. The reality is that the minimum feature set is 1) a tactic to reduce wasted engineering hours (code left on the floor) and 2) to get the product in the hands of early visionary customers as soon as possible. You’re selling the vision and delivering the minimum feature set to visionaries not everyone.” Steve Blank. Every potential customer does not need to value the MVP for it to be a success. Eric Ries elaborates: “Early adopters can be very forgiving of missing features. They see the vision and you can be in dialogue with them going through that learning feedback loop.” Operating in this process is faith that the customers will help evolve the MVP into something fantastic that will support a very profitable business with a scalable and repeatable business model.


Eric Ries: Minimum Viable Product: a guide

Eric Ries: What is minimum viable product?

Steve Blank: Perfection by Subtraction.

75% of Venture-backed Start-ups Fail

Eric Ries:

Steve Blank

Neil Patel: Developing an MVP: Your Key to Success

LinkedIn Founder Reid Hoffman’s Advice for Entrepreneurs


Minimum Viable Products in Biotech

Chris Dixon interviews Eric Ries:

Sam Altman:


A Minimum Viable Product Is Not a Product, It’s a Process

Eric Ries on 4 Common Misconceptions About Lean Startup

Why has the level of business competition levels been turned up to 11? Or: Why is the lean customer development process important?


The world has been fundamentally changed by digital networks and software. Businesses and customers which are connected by networked digital systems create amplified network effects which means the velocity of business and the level of competition and innovation are higher than they ever been ever been. To survive in this new environment every business, from the largest enterprises to the smallest sole proprietor, must accelerate and fundamentally change their customer development processes. Increasing the ability of a business to adapt to a changing world has never been more important. Virtually every niche in the business world is being constantly explored by challengers using a lean customer development process which I wrote about in my previous post. This constant experimentation by entrepreneurs makes profit harder than ever to sustain, especially if its source was traditionally information asymmetry (i.e., the buyer knew more about something than the customer). Unless a business has a moat based on something like network effects, there is nowhere to hide from the constant onslaught of competition.

Even if a business is fortunate enough to have a moat based on network effects, the life of a business can still be nasty, brutish and short. In other words, since network effects are brittle and work in both directions, a moat can be torn down just as fast or faster than the time it took to create it in the first place. Steven Sinofsky wrote a great Tweet on this point the day before yesterday: “It isn’t enough to build a better mousetrap. Your mousetrap must connect to all the other mousetraps and improve as mice evolve.” Steven is saying that it is not enough to write great software any more or create a great device. Network and network effects matter more than ever.

Once producers and customers are connected via digital networks and telemetry like usage data is being shared it is possible to use the lean start up process to find product/market fit in ways that are more effective, faster and cheaper than ever before. Experiments can be conducted at speeds that were never before possible. Intensifying the process further is that fact that competition can come from anywhere on the globe. I wrote in my post on Naval Ravikant:

“The cost of starting a company has collapsed.” “As the cost of running a startup experiment is coming down, more experiments are being run.”“Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money. Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money.” A capitalist economy is an evolutionary system.  Innovation and best practices are discovered by the experimentation of entrepreneurs who try to establish the evolutionary fitness of their business. Products and services created as part of this experimentation which have greater fitness survive and other less fit products and services die. Entrepreneurs are essentially running experiments in this evolutionary system when they create or alter a business.

“Success rates are definitely coming down but that is because the cost of running a startup experiment is coming down…so more experiments are being run. In the old days, we would have one company spend $10 million to figure out if it has a market. Today, maybe that same company could do it under $1-2 million. The capital, as a whole, may make the same or better returns, but yeah, if the failures don’t cost a half of what they used to, you are actually saving money, it is a more efficient market.” More experiments inevitably means more failures on an absolute basis. In addition, as the rate of business experimentation rises there will inevitably be an increase in the number of poseurs trying to create new businesses and that will increase failure rates. A lower overall success rate caused by an increase in the number of experiments is a positive trade off overall since society benefits from the increased level of innovation. This net benefit for society is created even though most experiments fail. What the collapse of the cost of running business experiments has done is radically increased the pace of the discovery process that creates innovation.

Any business that does not have connected customers who are sharing telemetry and a modern agile customer development process is bringing a pickle to a gunfight where the competitors have machine guns. Do products get created that do not use the lean process? Sure. That has always been the case. That vast majority fail and a few are a spectacular success creating a distribution that looks like a power law, but that is a topic for another post.

When I worked for Craig McCaw we would meet with various CEOs on a regular basis. It was interesting to see how different styles and approaches impacted business outcomes. One particularly memorable set of meetings we had involved a CEO who represented the third generation of his family to run a major public company which his grandfather started. When we met with him he was nearly always focused on macroeconomic issues like Federal Reserve interest rate policy and forecasts about the economy. Talking about these macro issues seemed to make him feel better. He never seemed to know much about his actual business. Over the years that business has declined to a point where all that is left today is the brand. It is a tragic story that negatively impacted not only him and his family, but tens of thousands of people. Of course, startup founders can fail for essentially the same reason at this CEO when they spend too much time on macro, attending industry conferences and shows and posing for photo shoots.

The CEO I am referring to attended one of the most well-known business schools in the world where he was taught that the systems his company had to deal with could be explained by concepts borrowed from physics like “equilibrium.” This was both unfortunate and fatal since the reality is that a capitalist economy is an evolutionary system and the best metaphor for how it works is biology rather than physics. Charlie Munger agrees: “I find it quite useful to think of a free-market economy – or partly free market economy – as sort of the equivalent of an ecosystem.” Unfortunately for people like this CEO there is no formula that will tell someone like him what to do. People who claim to have such a formulas are never right more than once in a row. The good news is that there are processes which can be followed that will greatly increase the probability of success. One process that killed the huge business was customer development. The pace at which new products were developed at his company was so ponderous and expensive that they were unable to react with sufficient speed when customer demand changed.

Fifty years ago this CEO would not have found himself in so much trouble so quickly. There has always been change in the business world and competition is not a new phenomenon in business. This was true during Georges Doriot’s heyday of the 1950s and 1960s, when he famously said “Someone, somewhere is making a product that will make your product obsolete” competition was significant. The competition Doriot describes is central to what Joseph Schumpeter called “creative destruction.” Schumpeter believed: “The process of industrial mutation—if I may use that biological term— incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” What is new about business today is that the many systems that make up businesses, markets and an economies are part of globally connected digital networks. When systems get connected via digital networks, feedback effects become stronger. When feedback effects get stronger, outcomes become more uncertain and nonlinear. This name Nassim Taleb gives to this phenomenon is Extremistan. Taleb advises that in such an environment:

“Be prepared for the fact that the next large surprise, technological or historical, will not resemble what you have in mind (big surprises are what some people call ‘unknown unknowns’). In other words, learn to be abstract, and think in second order effects rather than being anecdotal – which I show to be against human nature. And crucially, rare events in Extremistan are more consequential by their very nature: the once-every-hundred-year flood is more damaging than the 10 year one, and less frequent.”

Capitalism has always been an unforgiving system. Capitalism without failure is like religion without hell, it doesn’t work. There is something important and new happening with respect to the level of failure: digital systems that are connected via networks have turned the level of competition and innovation in the business world “up to 11.”

People are not unaware of this competition levels have been turned up to 11 phenomenon, which means they are starting fewer new business. I am not talking about venture capital backed businesses which are a tiny percentage of new business starts each year. In 2016 there we only 800 new businesses that received a series A financing round from a venture capital firms in the United States. What I am talking about is small businesses that are bootstrapped or rely on bank financing:


This competition levels turned up to 11 phenomenon is perhaps most easily explained by another example. Mike Lazaridis was working out at home on his treadmill in 2007 when he first saw an iPhone on a television.  Lazaridis is a co-founder of a business which at that time was selling millions of BlackBerry phones and secure network services to many of the world’s most famous people, including the President of the United States. The phone his business sold was nicknamed the CrackBerry since it was so addictive. The future of the business seemed as secure as its network.  It was not simply possible for Lazaridis to have fully realized the extent to which Apple’s iPhone was about to radically diminish the fortunes of the fabulously successful business he had created. The Globe and Mail newspaper describes what happened:

“That summer, he pried [an iPhone] open to look inside and was shocked. It was like Apple had stuffed a Mac computer into a cellphone. The iPhone broke all the rules. The operating system alone took up 700 megabytes of memory, and the device used two processors. The entire BlackBerry ran on one processor and used 32 MB. Unlike the BlackBerry, the iPhone had a fully Internet-capable browser. That meant it would strain the networks of wireless companies like AT&T, something those carriers hadn’t previously allowed. RIM by contrast used a rudimentary browser that limited data usage. Mr. Lazaridis recalled ‘It’s going to collapse the network.’ And in fact, sometime later it did. “If that thing catches on, we’re competing with a Mac, not a Nokia,” he recalled telling his staff.”

The iPhone, of course, would go on to be an industry and global phenomenon, pummeling the fortunes of BlackBerry and other businesses, reshaping several industries and changing the global economy. BlackBerry was not just competing with “a Mac in a phone” but an entirely new hardware, software and services ecosystem unlike anything the world had ever seen before.

This is a chart of the Blackberry stock price beginning about the time I started using their pager for the first time in 1999.


Another chart tells the story of how quickly the business changed:


What happened to BlackBerry can now happen to any business at any time. NYU Professor Aswath Damodaran points out: “We can no longer assume that competitive advantage will last a century as it used to for the old and mature companies. Instead competitive advantage for tech companies comes with a life span that continues to shorten. What this means is that you’ll climb faster as a business but fall faster too – Blackberry being a classic example.”

You are not employed by or invested in a tech business you say? Every business is now a tech business. There is no escape from Extremistan.  Let’s be clear about the point I am making here: I am saying that my generation rode a bike downhill to school both ways over a very short distance in balmy weather conditions and that young entrepreneurs today walk uphill both ways to school in the snow. Business is more competitive today than it ever has been. Thirty years ago my grandfather was a property developer who went to a club for lunch on most days where he played cards and had a cocktail. My friend’s dad was a stock broker who was playing tennis every day by 3:30 (on the West coast). There’s none of that any more that I can see. I would not want to go back to that time for any reason, but the competitive slack that existed in the system is gone. As another example of increased competition, I saw a woman in the grocery store last night “show rooming” containers of pre-washed lettuce on her phone (she was as an individual shopper comparing supermarket lettuce prices on a hand held supercomputer connected to the internet). That show rooming represents new competitive pressure which impacts the profitability of every product and service, from wealth management to services to retail of all kinds. Show rooming on mobile phones is great for consumers and is not going away! But for producers it adds to the competitive pressure they encounter every day.

Michael Mauboussin describes why the creative destruction process is inevitable: “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital.” Charlie Munger has said the same thing as Buffett many times, including this statement: “Over the very long-term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best. Capitalism is a pretty brutal place.”  Warren Buffett recently said during an interview at Columbia University: “The first question I ask myself when I look at a business, is it important and easy. And a lot of [businesses] don’t make it. I’m looking for the one-foot bars to step over versus the eight-foot bars to jump over.”

When it comes to moats, durability matters. Some moats atrophy gradually over time and some much more quickly. This is not a completely new phenomenon. As Ernest Hemingway once said in his book The Sun Also Rises, a business can go bankrupt in two ways: gradually and then suddenly. The speed of moat destruction has greatly accelerated over time due to advances in technology and the way it spreads information. For some people this increase in speed can at times be disorienting. For example, the speed at which a company like Blackberry lost its moat was shocking to many investors and employees. This disorientation is having many second and third order effects like heightened political discord. People in many cases are terrified about losing their jobs. Angry, scared and confused people can do unexpected things.

How long a moat lasts in a business is called a “Competitive Advantage Period” (CAP) writes Michael Mauboussin. The speed of moat dissipation will be different in each case and need not be constant.  The rate at which a moat atrophies is similar to what academics call “fade” argues Mauboussin. Even the very best companies can see competition make their moats shrink or even disappear. Munger has said: “Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.”

That moats are hard to create and inevitably deteriorate over time is one very important reason why capitalism works. What happens over time is so-called “producer surplus” is transferred into “consumer surplus.” What I am saying in this post is that I suspect that the average “competitive advantage period” (CAP) of a business is shrinking. There is some supporting data such as a study which concludes: “over time competitive advantage has become significantly harder to sustain …seen across a broad range of industries.”

To illustrate the points I have made in this post with an example, if a business person opens a successful restaurant that success will inevitably attract imitators and competitors. Some of these restaurants will adapt and survive and thrive and others will fail. Charlie Munger describes the process: “The major success of capitalism is its ability to drench business owners in feedback and allocate talent efficiently. If you have an area with 20 restaurants, and suddenly 18 are out of business, the remaining two are in good, capable hands. Business owners are constantly being reminded of benefits and punishments. That’s psychology explaining economics.” The consumer wins because the products and services offered to them get better and better over time. What happens over time is what economists call “producer surplus” is transformed into “consumer surplus.” Producer surplus is lower since competition has been turned up to 11 and this makes GDP growth look anemic, but competition and innovation are anything but anemic. In Extremistan, producer surplus becomes consumer surplus faster. For a business this is problematic since producer surplus is what delivers the profits that makes the process called capitalism work.


25iq post on Naval Ravikant